Download The Gold Standard, Bretton Woods and Other Monetary Regimes: A

123
Michael TI. Bordo
Michael D. Bordo is a professor of economics at Rutgers
University and a research associate of the National Bureau of
Economic Research. For excellent research assistance I
would like to thank Jakob Koenes. For helpful comments and
suggestions I am grateful to Barn,’ Eichengreen, Allan Meltzer,
Leslie Presnell, Hugh Rockoft and Anna Schwartz.
• I The Gold Standard, Bretton
Woods and Other Monetary
Regimes: A Historical
Appraisal
INTRODUCTION
Two Questions
Which international monetary regmm is h ~5t
for economic performance? One based on fixed
exchange rates, including the gold standard and
its variants? Adjustable peg regimes such as the
Brel ton Woods system and the European Monetarv System (EMS)? Or one based on floating
exchange rates? This quest ion has been debated
since Nurkse’s classic indictment of flexible rates
and Friedmans classic defense.
Why have some none tarv regimes been more
successful than others? Specifically, why did the
classical gold standa id last for almost a ceo t urv
(at least for ( reat Britain) and why did Bret ton
Woods endure for only 25 years (or less)? Why
was the EMS successful for only a few years?
This paper attempts to answer these questions
lo answer the first question, I examine empirical evidence on the performance of three moneta rv regimes: the classical gold s andard Brett on
Woods, and the current float. As a backdrop, I
examine the mixed regime interwar period. I answer
the second question by linking regime success
to the presence of credible commitment mechanisms, that is, to the incentive compatibility features of the regime. Successful fixed-rate regimes,
in addition to being based on simple transparent
rules, contained lea tures tim t en conraged a center
country to enforce the rules and other countries to comply.
The Issues
These questions touch on a number of important issues raised in economic literature. ‘Ihe
first is the effect of the exchange rate regime
on welfare. The key advantage of fixed
exchange rates is that they reduce the transactions costs of exchange. The key disadvantage is
that in a world of wage and price stickiness the
benefits of reduced transactions costs may he
on tweighed by the costs of more volatile output
and employment.
Helpman and Razin (1979), Helpinan (1981)
and others have raised the welfare issue. This
theoretical literature concludes that it is difficult
to provide an unambiguous ranking of exchange
rate arrangements
-
Meltzer 11990) argues the need for empirical
1
See Nurkse (1944) and Friedman (1953).
2
See DeKock and Grilli (1989 and 1992).
MARCH/APRIL 1993
124
measures of the excess burdens associated with
flexible and fixed exchange rates—the costs of
increased vo)a tili tv on the one hand compared
with the output ccsts of sticky pnces on the
other hand. His comparison of EMS and nonEMS countries in the postwar period however,
does not yield clear-cut results.
Earlier literature comparing the macroeconomic performance of the classical gold stand-
ard, Bret ton Woods and the current float also
yielded mixed results. tIm-do (1981) and Cooper
(1982) showed that the classical gold standard
was associated with greater price level and real
output vola t ilitv than post—World War II arrangements for the United States and United Kingdom.
On the other hand Klein (1975) and Schwartz
(1986) presented evidence that the gold standard provided greater long-term lirice stahilit~’
than did the post—World War- It arrangements.3
Bordo (1993) compared the means and standai-d deviations of nine variables for the Group
of Seven countries under the three regimes, as
well as the interwar period4 According to these
measm’es, the Bretton Woods convertible period
from 1959 to 1971) was the most stable regime
for the majority of countries and variables
examined. Eichengreen 1 1992a) measured volatility applying two filters (the first difference of
logarithms and a linear trend).~Comp n’ing Bretton Woods and the float for a sample of 10
countries, he found no clear-cut connection
between the volatility of real growth and the
exchange rate regime. He also found no significant difference in the correlation of output volatility across countries between the two regimes.
A second issue is whether the exchange rate
regime provides insulation from shocks and
monetary policy independence. Under fixed
rates, coordinated monetary policy may provide
effective insulation from common supply shocks,
but not from country-specific shocks. tinder
~Thisresult is disputed by Mettzer and Robinson (1989).
4
The Group of Seven countries are Canada, France, Germany, Italy, Japan, the United Kingdom and the United
States.
5
Eichengreen followed the methodology of Baxter and
Stockman (1989).
t
Similarty a monetary union such as the proposed European Monetary Union could provide effective insulation
from common supply shocks for its members. However,
giving up monetary independence imposes additional burdens in the case of member-specific (regional) shocks,
Feldstein (1992).
7
Addressing the issue of the optimum currency area, Bayoumi and Eichengreen (1992b, 1992c and 1992d) also
FEDERAL RESERVE BANK OF ST. LOUIS
flexible rates, coun try-specific shocks can be offset by independent monetary policy.°
The evidence on this issue is limited. Bavoumi
and Eichengreen (1 992a) applied the ElanchardQuah appi-oach to show that both supply (permanent) and demand (temporary) shocks, for a
sample of live countries, were considerabh’ greater
under the gold standard than under post—World
War II regimes. However, they found little difference in the incidence of shocks between
Bretton Woods and the floating exchange rate
regime. Their results also showed that the dispersion of shocks across countries was higher
under the gold standard than under the two
more recent regimes and slightly higher under
llretton Woods than under the floating exchange
rate regime. They attributed the ability of the
gold standard to withstand greater shocks to evidence of a faster speed of adjustment of both
prices and output, as measured by impulse
response frmctions.~
A third issue is the case for rules vs. discretion. A fixed exchange rate max’ he viewed as a
commitment mechanism or rule. It binds the
hands of polic makers to prevent them from
following inflationary discretionary policiesi
The monetary authority, in a closed economy or
under flexible rates, might be tempted to engineer an inflation surprise to raise ret-enue.” ‘lie
outcome is higher inflation because the public,
assuming rational expectations, will anticipate
the policy. Wet-c some credible mechanism,
such as a monetary rule, in place the expansionarv policy would not he implemented. Alternativelv, a commitment to a fixed exchange rate
through a pledge to maintain gold convertibility,
for example could achie~’ethe same results, hut
because it is more transparent, it would possibly
cost less. 10 Such binding commitments may, however, be undesir-ahle in the presence of extreme
emergencies such as major wars, supply shocks
or financial crises.11 Undet- such circumstances
apply this methodology to examine the incidence of
shocks within Western Europe and within regions of North
America.
8
See Kydland and Prescott (1977), Barro and Gordon
(1983), and Persson and Tabellini (1990).
9
Alternatively the monetary authority may create an inflation
surprise to offset a labor market distortion that raises the
unemployment rate above some desired level.
10
5ee Giavazzi and Pagano (1988).
11
5ee Rogoff (1985a) and Fischer (1990).
125
a contingent rule, or one with escape clauses
that allow member countries to suspend parity
(convertibility) temporarily, may be optimal.12
The rule constrains the government to adhere to
the fixed exchange i-ate except in the case of a wellunderstood emergency, ~~‘lienit can suspend
pal-it)’ (convertibility under the gold standard)
and issue fiat money. Once the emergency has
passed, with allowance for a suitable delay, the
authority is expected to return to the rule—that
is, to the fixed rate at the original parity. If the
putilic believes in the government’s commitment
to return to the rtile, the government will be able
to raise more revenue than it could with no credibility. ‘the inflation rate during the emergency
would he higher than undet- the rule (when presumably it would he zero) hut tess than in the
case of put-c discretion. The pattern of alternatbig fixed and floating exchange rate regimes
over the past 200 years may he well explained
by adherence to a rule with an escape clause. 13
On the other hand, in a regime of floating
exchange rates the inflationary bias of discretionai-y policy may he overcome by instituting
ct-edible monetary rules or other conimitment
mechanisms, such as an independent conservative central hank.’~Such mechanisms may Prevent the perceived disad~-antageof sacrificing
national sovereignty to the supernational (lictates of a fixed exchange rate.
A fourth issue is that of international coopet-anon and policy coordination. Recent game theory
literature has demonstrated that coordination of
policies (by fixing exchange rates) can offset spillover effects fi-om uncoordinated policy actions. IS
Cooperative fixed exchange rate arrangements,
however, unless enforced by a supernational auhot-it)’ whose power exceeds national sovel-eignt\’,
tend to break down as individual members devalue. Cooperation is more likel without a
supet-nat ional authority, in a world of repeated
games because the benefits of reputation can
offset the advantages to each count i-v of cheating. “‘ But even in this case, cooperation between
nations may pl-odlucd~tninflationary bias when
no credible commitment mechanism is present
to pt-event governments from following discre,
tionaty policies. 17 Thus for an international monetaty arrangement to be effective both between
countries and! within them, a consistent credible commitment mechanism is required. Such a mechanism
likely prevailed under the gold standard but
was less evident under Bretton Woods.
A fifth and final issue is the case for international
monetary refoi-m. Several, prominent proposals
have been made to reform the present managed
floating exchange rate regime and move it hack
toward one of greater fixity. These proposals in
part derive from a pet-ception, based on the
historical record, that fixed exchange rates are
preferable to the current float. These proposals
include McKinnon’s case for a gold standard without gold, Mundell’s proposal to target the real
price of gold and the case for target exchange
rate zones presented by Williamson and Bergsten)’ Even more immediate is the move to convert the adjustable peg of the EMS to a
unified currency area with irrevocably fixed
exchange rates.
()tTtSftTjp
tif
The paper accomplishes a number of tasks.
The next section answers the first question,
which international monetary regime is best for
economic performance, by presenting a compilaRon of statistical evidence on different aspects
of the lierforniance of alternative monetary
regimes. The measures cover the stability of
several macroeconomic variables; the dispersion
of macroeconomic yariabtes across countries;
the lielsistence of inflation; forecast errors in
inflation and growth; the incidence of supply
(permanent) and demand (temporary) shocks;
the dispersion of shocks between countries; and
the mean response of prices and output to sup‘ily and demand shocks. The third section
stresses the importance of adhering to credible
rules in a historical examination of three international monetary regimes: the classical gold!
standard, Bretton Woods and the EMS. The
final section answers the question why some
regimes endured longer than others. It concludes Ii)’ discussing why even a regional
exchange rate arrangement—the EMS—has consiclerahle difficulty surviving.
2
‘ See Bordo and Kydland (1992), Flood and Isard (1989a
and 1989b), and DeKock and Grilli (1989 and 1992).
“See DeKock and Grilli (1989) and Giovannini (1992).
4
‘ See Rogoff (1985a).
“See
17
See
18
5ee
and
Dominguez (1993).
Rogoff (1985b).
McKinnon (1988), Mundelt (1992), Williamson (1985a)
Bergsten (1992).
“See Hamada (1979) and Canzoneri and Henderson (1988
and 1991).
MARCHIAPRlL 1993
126
‘the statistical evidence on performance of alternative monetary r-egimes in the next section makes it
clear that the performance of regimes in the post—
World War II era is superior to that of the regimes
in the precedhlg half century. The key exception
is the classical gold standard, which exhibits the
lowest inflation persistence and a relatively high
degree of financial market integration. The l3retton
Woods convet-titile regime from 1959 to 1970 performed the liest by far on virtually all criteria
The greater durability of the gold standard compared with llretton Woods cannot he explained
by a lower incidence of shocks. The key explanation for its success lies with the credibility of
the commitment to the gold standard rule of
convertibility by England and the other core
countries and its near universal acceptance. As a
contingent rule, it was flexible enough to withstand the major shocks that buffeted it. ‘I’he
Bretton Woods adjustable peg was in some respects similar to the gold standard contingent
rule, hut it invited speculative attack hence
weakening the escape clause. Unlike England,
the leading country before World War I, the
United States, the dominant country under Bretton Woods, maintained a credible commitment
to a noninflationary policy for (inly a few years.
‘the world, faced with imported inflation in the
late 1960s, lost the incentive to follow its leadership, and the system collapsed in 1971
The longevity of general floating exchange
rate regimes since 1973 suggests that the lessons
of Brett ~n Woods have been well learned. Countries are willing to subject their domestic policy
autonomy neither to that (if another country
whose commitment they cannot tie sure of in a
stochastic world, nor to a supernational monetary
authority they cannot control. Even the recent
experience of the EMS—a regional exchange rate
arrangement het\veen countries su1iposediy pursuing common goals—revealed differing national
priorities in the face of asymmetric shocks that
placed intolerable strains on the system.
-
-
1~
lalso examined the period (1946—73) which includes the
three years of transition from the Bretton Woods adiustable peg to the present floating regime. The results are
similar to those of the 1946—70 period.
“The common world price level under the gold standard,
however, exhibited secular periods of deflation and inflation reflecting shocks to the demand for and supply of
gold. See Bordo (1981) and Rockoff (1984). A welldesigned monetary rule, it is argued, could have prevented
the long-run swings that characterized the price level
under the gold standard. See Cagan (1984).
21
See Giovannani (1992).
“See Bordo and Schwartz (1989a).
FEDERAL RESERVE BANK OF ST. LOUtS
THE PERFORMANCE
NATIVE MONETARY
OF ALTEW
REGIMES
‘to make the case for- one monetary regime
over another, empirical and historical evidence
on their performance is crucial. In this section
I present some evidence on different aspects of
the macroeconomic perfom-mance of alternative
international monetary regimes over the past
110 years. The comparison for the seven hn’gest
(non-Communist) industrialized countries (the
Group of Seven countries) is liased on annual
data for the classical gold standard (1881—4913),
the interwar period (1919—39), Llretton Woods
(1946—70), and the present floating exchange
rates i-egimne (1971—89). The Bretton Woods
period (1946—70) is divided into two suhperiods:
the preconvertible phase (1946—58) and the convertilile phase (1959—70).’~
The comparison relates to the theoretical issues
raised by the debate over fixed vs. flexible exchange rates. According to the traditional view,
adherence to a (commodity-based) fixed exchange
rate regime, such as the gold standard, ensured
long-run price stability for the world as a whole
because the fixed price of gold provided a mmminal anchor to the world money supply. Individual nations, by pegging their currencies to gold),
fixed) their price levels to that of the world.30 A
fixed-rate system based on fiat money, however,
may not lirovide a stable nominal anchor unless
a cr-edible commitment mechanism constt-ains
the growth of the world’s money supply.~~
The
disadvantage of fixed rates is that individual
nations are exposed to both monetary and real
shocks transmitted from the rest of the world
through the balance of payments and other
channels of transmission.” The advantage of
floating exchange rates is to provide insulation
from foreign shocks. The disadvantage is the
atisence of the discipline of the fixed-exchangerate rule because monetary authorities night
adopt inflationary policies
-
127
Theoretical developments in recent years have
complicated the simple distinction between fixed
and floating exchange rates. In the presence of
capital mobility, currency substitution, policy
reactions and policy interdependence, floating
rates no longer necessarily provide insulation
from either real or monetary shocks.83 Moreover,
according to recent real business cycle approaches,
there may be no relationship between the international monetary regime and the transmission
of real shocks.” Nevertheless, the comparison
between regimes may shed light on these issues.
One important caveat is that the historical
regimes presented here do not represent clear
examples of fixed and floating exchange rate
regimes. The interwar period comprises three
regimes: a general floating rate system from
1919 to 1925, the gold exchange standard from
1926 to 1931 and a managed float to 1939.”
The Bretton Woods regime cannot be characterized as a fixed exchange rate regime throughout
its history: The preconvertibility period was close
to the adjustable peg envisioned by its architects,
and the convertible period was close to a de facto
fixed dollar standard.2’ Finally, although the
period since 1973 has been characterized as a
floating exchange rate regime, at various times it
has experienced varying degrees of management.
Stability and Convergence
Table 1 presents descriptive statistics on nine
macroeconomic variables for each Group of
Seven country, with the data for each variable
converted to a continuous annual series from
1880 to 1989. The nine variables are the rate of
inflation; real per capita growth; money growth;
short-term nominal interest rates; long-term
nominal interest rates; short-term real interest
rates; long•term real interest rates; and the
absolute rates of change of nominal and real
exchange rates. The definition of the variable
23See Bordo and Schwartz (1989a).
245ee Baxter and Stockman (1989).
2STo be more exact, the United States stayed on the gold
standard until 1933, and France stayed until 1936. For a
detailed comparison of the performances of these three
regimes In the Interwar period, see Eichengreen (1991 a).
83Wlthln the sample of seven countries, Canada floated from
1950 to 1961.
2Tfl~j~
Is a very crude measure of convergence or divergence between the different countries’ summary statistics.
Because It Is based on the average for the whole period, It
suppresses unusual movements within particular subperiods. Bayouml and Elchengreen (1992d) presented an
aftemative measure of convergence or dispersion—the
GDP-welghted standard deviation of the lndMdual country
used, for example, Ml vs. M2, was dictated by
the availability of data over the entire period.
For each variable and each country I present
two summary statistics: the mean and standard
deviation. For the countries taken as a group,
I show two summary statistics: the grand mean
and a simple measure of convergence defined
as the mean of the absolute differences between
each country’s summary statistic and the grand
means of the group of countries.27 I comment
on the statistical results for each variable.
Inflation. Countries using the classical gold
standard had the lowest rate of inflation and
displayed mild deflation during the interwar
period. The rate of inflation during the Bretton
Woods period was on average and for every
country except Japan lower than during the
subsequent floating exchange rate period. The
average rate of inflation in the two Bretton
Woods subperiods was virtually the same. This
comparison, however, conceals the importance
of two periods of rapid inflation in the 1940s
and 1950s and in the late 1960s. See figure 1.23
Thus the evidence based on country and period
averages of very low inflation in the gold stand.
ard period and of a lower inflation rate during
Bretton Woods than the subsequent floating
period is consistent with the traditional view on
price behavior under fixed (commodity-based)
and flexible exchange rates.
In addition, the inflation rates show the highest
degree of convergence between countries during
the classical gold standard and to a lesser extent
during the Bretton Woods convertible subperiod
compared with the floating rate period and the
mixed interwar regime. This evidence also is
consistent with the traditional view of the oper.
ation of the classical price specie flow mechanism
and commodity arbitrage under fixed rates and
insulation and greater monetary independence
under floating rates?
-
series around the G-7 aggregate. I calculated this Sterna~
tive measure of convergence for the data in table 1. The
results are very close to those reported here for virtually
every variable.
2tThe data sources for figure 1 and all subsequent figures
are listed in the Data Appendix to Bordo (1993).
29For similar evidence see Bordo (1981), Darby, Lothlan
et.al. (1983) and Datby and Lothian (1989).
MARCH/APRIL 1993
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MARCH/APRIL 1993
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MARCH/APRIL
1993
132
Figure 1
Inflation Rates, 1880-1989, G7 Countries
Percent
1880
1890
J —
1900
1910
U.S.
—
1920
1930
1940
U.K.
1950
1960
1970
—
Germany
1980
1990
Canada
Percent
1
1880
1890
—
1900
1910
France
FEDERAL RESERVE BANK OF ST. LOUIS
1920
1930
1940
Italy
1950
1960
=
1970
1980
Japan
1990
133
The Bretton Woods convertible subperiod had
the most stable inflation rate of any regime as
judged by the standard deviation. By contrast,
Ihe preconvertible Bretton Woods period exhibited
greater inflation variability than either the gold
standard period or the recent floating exchange
rate period. The evidence of a high degree of
price stability in the convertible phase of Bretton
Woods is also consistent with the traditional
view that fixed rate (commodity-based) regimes
provide a stable nominal anchor; however, the
remarkable price stability during this period
niay also reflect the absence of major shocks.
Real per capita GNP. Generally, the Bretton
Woods period, especially the convertible period,
exhibited the most rapid output growth of any
monetary regime, and not surprisingly the interwar period the lowest (see figure 2). Output
variability was also lowest in the convertible
subperiod of Bretton Woods, but because of
higher variability in the preconvertible period,
the Bretton Woods system as a whole was more
variable than the floating exchange rate period.
Both pre—World War 11 regimes exhibit higher
variability than their post—World War H counterparts3° The divergence of output variability
between countries was also lowest during the
Bretton Woods regime, with the interwar regime
showing the highest divergence.~’The greater
convergence of output variability under Bretton
Woods may reflect conformity between countries’
business fluctuations, created b the operation
of the fixed exchange rate regimea2
Money growth (M2). Money grew considerably more rapidly across all countries after
World War II than before the war (see figure 3).
There is not much difference between Bretton
Woods and the subsequent floating exchange
rate regime. Within the Bretton Woods regime,
money grew more rapidly in the preconvertibility
period than in the convertibility period. Money
growth rates showed the least divergence between
30
Baxter and Stockman (1989) and Eichengreen (1992a) use
residuals
linear trend to the logarithm of real output
as a detrending filter rather than the logarithmic first ditference used here. According to their results, real output
from
a
variability is not greater in the floating than in the fixed
period.
31However, using their alternative measure of convergence—
the GDP-weighted standard deviation of the individual
country series around the G-7 aggregate—Bayoumi and
Eichengreen (1992a) report that the lowest degree of dispersion of real GDP growth was in the floating rate period,
followed by the Bretton Woods convertible period. Similar
results hold for the real GNP per capita data in table 1.
For Bayoumi and Eichengreen (1992a) the decline in the
countries during the fixed-exchange-rate gold
standard and the convertible Bretton Woods
regime, with the greatest divergence in the
preconvertible Bretton Woods period and the
interwar period.
Like inflation and real output variability, money
growth variability was lowest in the convertible
Bretton Woods period. This, however, was not
the case for the preconvertible period, which
was the most variable of any regime. It also
exhibited the greatest divergence in variability
between countries. To the extent that one of
the properties of adherence to a fixed-exchangerate regime is conformity of monetary growth
rates between countries, these results are sympathetic to the view that the Bretton Woods
system really began in 1959.
Short~ternj and long-terni interest rates,
The underlying data for short-term and longterm interest rates are seen in figures 4 and 5.
As in other nominal series, the degree of convergence of mean short-term interest rates is
highest in the convertible Bretton Woods
period. Long-term rates are most closely related
in the classical gold standard regime, with the
convertible Bretton Woods period not far behind.
McKinnon (1988) has similar findings, He views
them as evidence of capital market integration
under fixed exchange rates. The lack of convergence in the preconvertihility Bretton Woods
period reflects the presence of pervasive capital
controls. Convergence of nominal interest rates
would not be expected under floating exchange
rates. Convergence of standard deviations is also
highest in the gold standard period followed by
Bretton Woods. Long-term rates were most stable
and least divergent under the classical gold standard, followed by the two Bretton Woods suhperiods,
with floating exchange rates the least stable, The
evidence that nominal interest rates are more
stable and convergent between countries under
fixed exchange rate (commodity-based) regimes
is consistent with the traditional view.
dispersion real growth and the rise in the dispersion of
inflation rates between the Bretton Woods convertible
period and the float have the following explanations: the
move to flexible rates allowed countries to stabilize their
relative growth rates in the face of asymmetric supply
shocks the expense of their relative inflation rates. They
also report that, when they apply the linear trend filter of
Baxter and Stockman (1989), evidence of a rise in the
cross country correlation between output movements after
of
at
1970 is considerably reduced.
32
5ee Bordo and Schwartz (1989a) and Darby and Lothian
(1989).
MARCH/APRIL 1993
134
Figure 2
Per Capita Income Growth Rates, 1880-1989, G7 Countries
Percent
20
1880
1890
—
1900
U.S.
1910
—
1920
1930
ILK.
1940
—‘---
1950
1960
Germany
1970
1980
1990
Canada
—
Percent
50
40
30
20
10
0
-10
-20
-301880
1890
—
1900
1910
France
FEDERAL RESERVE SANK OF ST. LOUIS
1920
1930
—
1940
Italy
1950
1960
=
1970
1980
Japan
1990
135
Figure 3
Money Growth Rates, 1880-1 989, G7 Countries
Percent
1880
1890
—
1900
1910
U.S.
—
1920
1930
U.K.
1940
1950
1960
Germany
—
1970
—
1980
1990
Canada
Percent
100
90
80
70
60
50
40
30
20
10
0
-10
-20
-30
-40
1880
1890
—
1900
France
1910
1920
1930
—
1940
Italy
1950
1960
=
1970
1980
1990
Japan
MARCH/APRIL 1993
136
Figure 4
Short-Term Interest Rates, 1880-1989, G7 Countries
Percent
1
17
16
15~
14
13
12
11
10
9
8
7
6
4
3
2
1
0
1880
J
1890
—
1900
1910
—
U.S.
1920
1930
U.K.
1940
fl—”
1950
1960
Germany
1970
1980
1990
Canada
—“
Percent
1716151413-
—
1211—
109876
5
43
2
1
1880
1890
I
I
I
I
1900
1910
1920
1930
—
France
FEDERAL RESERVE BANK OF ST. LOUIS
1940
1950
I
I
I
1960
1970
1980
—
Japan
1990
137
Figure 5
Long-Term Interest Rates, 1880-1 989, G7 Countries
Percent
1880
1890
1900
1910
—
U.S.
—
1920
1930
U.K.
1940
1950
1960
1970
Germany
—‘---
1980
1990
Canada
—
Percent
22
21
2019-
18-
1716151413-
1211—
1098765
4
321880
I
I
I
I
I
I
I
I
I
1890
1900
1910
1920
1930
1940
1950
1960
1970
—
France
—
Italy
—
1980
1990
Japan
MARCH/APRIL 1993
138
Real short-term and real long-term
interest rates. For the underlying real shortterm and real long-term interest rate data, see
fIgures 6 and 7. The real interest rates are cx
post rates calculated using the rate of change of
a consumer price index.~~
Unlike the nominal
series, the degree of convergence in means
between real short-term interest rates is lowest
in the floating exchange rate period, next lowest
in the Bretton Woods convertible period and
highest in the preconvertible period. Fot longterm real rates, as in the case of nominal rates,
convergence is highest under the gold standard
followed by the Bretton Woods convertible regime.
It is lowest under preconvertible Bretton Woods.
The real short-term interesl rate is most stable
across countries during the Bretton Woods convertible period. It also shows the least amount
of divergence in standard deviations. The same
holds fot- real long-term interest rates.
The behavior of real interest rates across
regimes is consistent with McKinnon’s explana~ He argued that fixed exchange rates
encourage capital market integration by eliminating devaluation risk. This reduces variability
in short-term real interest rates. Similat-ly,
real long-term interest rates ate stabilized by
pooling across niarkets, which reduces capital
market risk.
Nominal and real exchange rates. The
lowest mean rate of change of the nominal exchange rate arid the least divergence between
rates of change occurred during the Bretton
Woods convertible amid gold standard periods,
with the former exhibiting the lowest degree of
divergence. Exchange rates during the preconvertihility Bretton Woods regime changed almost
as much as during the floating pet-iod. This
mainly reflected the major devaluations of 1949
(see figure 8l.’~Nominal exchange rates were
least variable in the gold standard and convertible Bretton Woods periods and the most variable and most divergent in the Bretton Woods
preconvertible period.
As with the nominal exchange rate, the lowest
mean rate of change in the real exchange rate
33
i~— Alog ~ where i~is
Define the real interest rate as r,
the nominal interest rate and Alog P~ log P~ log P,_1
is the percentage change in the consumer price index.
34See McKinnon (1988).
35See Bordo (1993) table 2.
=
=
3t
—
Also see Dornbusch (1976).
“Stockman (1983 and 1988) argues that greater variability
FEDERAL RESERVE BANK OF ST. LOUIS
across countries and the least divergence
between countries was in the Bretton Woods
convertible period, with the divergence in gold
standard period next smallest (see figure 9). The
highest rate of change was in the floating
exchange rate period. Similarly data from the
Bretton Woods convertible period had the
lowest standard deviation across countries and
the least divergence between standard deviations, with the gold standard again next in these
rankings. The other t-egimes were characterized
by much greater variability and divergence.
These results shed light on the i-elationship
between the nominal exchange rate regime and
the behavior of real exchange rates. Mussa
(1986) presented evidence for 16 industrial
countries in the post—World War IT period
showing the similarity between nonunal and
real exchange rate variability under floating
rates. His explanation for greater real exchange
rate variability under floating rates than under
fixed rates is nominal price rigidity.~°
The explanation may, however, be questioned. For example, a fixed nominal exchange rates may produce
greater trade stability that will be reflected in
the real exchange rate, as is evident for both
the Bretton Woods and gold standard periods.
Yet as Eichengreen (1991b) points out and as
can be seen in table 4, these results could be
explained by the fact that both periods were
characterized by few shocks.”
Finally, based on monthly data between 1880
and 1986 for the United Kingdom and the United
States, Grilli and Kaminsky show that, with the
exception of the post—World War II period, no
clear connection exists between the nominal
exchange rate regime and the variability of real
exchange rates.33 My mesults for the Group of
Seven countries show a clear correlation
between nominal exchange rate rigidity arid
lower real exchange rate variability for the gold
standard and Bretton Woods cotivei’tible regime.
For the preconvertibie Bretton Woods period—
de jure a type of fixed exchange rate regime—
the correlation is not evident. I do not distinguish between fixed and flexible periods in the
interwar segment as do Grilli and Kaminsky,
in real exchange rates under floating rates than under
fixed rates reflects the response of real exchange rates to
productivity shocks, with changes in the real exchange
rate producing nominal exchange rate volatility. This volatility is offset under fixed rates by exchange market intervention.
38See Grilli and Kaminsky (1991).
139
Figure 6
Real Short-Term Interest Rates, 1880-1989, G7 Countries
Percent
1880
j
1890
1900
=
U.S.
=
1910
1920
1930
1940
—
UK.
1950
1960
Germany
1970
1980
Canada
—
1990
j
Percent
1880
1890
1900
—
1910
Japan
1920
1930
1940
1950
1960
—
1970
1980
1990
France
MARCH/APRIL 1993
140
Figure 7
Real Long-Term Intereét Rates, 1880-1989,07 Countries
Percent
1880
1890
—
1900
1910
U.S.
—
1920
1930
U.K.
1940
——
1950
1960
1970
Germany
—
1980
1990
Canada
Percent
1880
1890
—
1900
1910
France
FEDERAL RESERVE BANK OF ST. LOUIS
1920
1930
—
1940
Italy
1950
1960
=
1970
1980
Japan
1990
141
Figure 8
Absolute Change in Nominal Exchange Rates, 1880-1989, G7 Countries
Percent
1880
I
1890
1900
=
U.K.
1890
1900
1910
1920
—
1930
1940
1950
1960
1970
—
Germany
1980
1990
Canada
Percent
1880
=
France
1910
1920
1930
1940
—
Italy
1950
1960
1970
—
1980
1990
Japan
MARCH/APRIL 1993
142
Figure 9
Absolute Change in Real Exchange Rates, 1880-1989,07 CountrIes
Percent
1880
j
1890
—
1900
1910
1920
1930
—
U.K.
1940
1950
Germany
1960
1970
1980
1990
Canada
—
Percent
80
70
60
50
40
30
20
10
1880
1890
=
1900
1910
France
FEDERAL RESERVE BANK OF ST. LOUIS
1920
1930
—
1940
Italy
1950
1960
1970
—
1980
Japan
1990
143
hence that period cannot be used in the compaiison.3°
In summary, the Bretton Woods regime exhibited
the best overall macroeconomic performance of
any regime. ‘this is especially so fot the convertible period (1959_70L4tt As the summary
statistics in table 1 show, both nominal and i-eat
variables were mnost stable in this period. The
floating exchange rate regime, on most criteria,
was not far behind the Bretton Woods convertible regime, whereas the classical gold standard
exhibited the most stability and the closest convergence of financial variables.
The preconvertible Bretton Woods petiod (1946—
58) was considerably less stable fot the average of
all countries for both nominal amid real vaiiahles
than other regimes. Also both nominal and i-cal
variables did riot vary nearly as closely together.
i’hese differences likely reflect the presence of
pervasive exchange amid capital controls before
1958 and, related to these, more variable and
more rapid monetary growth. These data, however, are limited. Although they show excellent
performance for the convettible Bretton Woods
regime, they do not tell us why it did well—
whethet- it reflected a set of favorable circumstances, whether it reflected the absence of
aggravatimig shocks, whether it reflected stable
monetary policy by the key country of the system, the United States, or whether it masked
underlying strains to the system.
Inflation Persistence
A second piece of evidence is persistent inflation. Evidence of persistence in the inflation
rate suggests that market agents expect the
monetary authorities to continually follow an
inflationary policy; its absence would be consistent with the belief that the authorities are following a stable momietat-y tule, such as the gold
standard’s convertibility rule. Barsky (1987) presented evidence for the United Kingdom and
United States based on both autocort-elations
and time set-ies models that inflation under the
tt
Meltzem (1990) in a comparison of EMS and non-EMS contries in the floating rate period also finds a strong correla40tion between changes in nominal and real exchange rates.
McKinnon (1992) treats the period 1950 to 1970 as the
de facto dollar standard. He views this period rather than
1959 to 1971 as the appropriate one for making the type
of regime comparisons undertaken here. I made the same
calculations as those shown in table I for the period 1950
to 1971. Virtually every variable for each country exhibited
greater instability than in the 1959 to 1970 period. This
reinforces my choice of dates.
gold standard was very nearly a white-noise
process, whereas in the post—World War H
period, the inflation rate exhibited considerable
persistence. Alogoskoufis and Smith (1991) also
show, based on AR(1) regressions of the inflation rate, that inflation persistence in the two
coufitmies increased between the classical gold
standamd period and the interwar peiiod and
between the interwar period and the post—World
War II period.41
Table 2 presents the inflation-rate coefficient
from the type of Affil) regressions on consumer
price index inflation estimated by Alogoskoufis
and Smith, for the Group of Seven countries
over successive regimes since 1880, as well as
the standard errors and the Dickey-Fuller tests
for a unit root.”
The results, as in Alogoskoufls and Smith, show
an increase in inflation persistence fot- most
countties between the classical gold stanclat-cl
and the interwar period, and also between the
interwar period and the post—World War IT
period as a whole. Within the post—World War
II period, inflation persistence is generally lower,
with the exceptions of France and Japan, in the
preconvertible l3retton Woods thati the convertible
period. This suggests that though the immediate
post—World War Il period was characterized by
rapid inflation, market agents may have expected
a return to a stable price regime. The higher
degree of persistence in the convet-tibte regime
suggests that this expectation lost credence. Finally,
the evidence that persistence was generally
highest during the floating exchange rate regime
may imply that the public realized that them-c
was no longer a stable nominal anchom’.
Forecast Errors in Inflation and
Growth
A third piece of evidence relates to the forecast
errors of inflation and real output gt-owth. According to Mettzer and Robinson (1989), “a welfare
maximizing muonetary rule would reduce variability to the niinimum inherent in nature and
41
Also see Alogoskoufis (1992), who attributes the increase
persistence to the accommodation by the monetary
authorities of shocks. This evidence is also consistent with
the results of Klein (1975).
4t
Eichengreen (1992b) also presents these statistics for four
of the countries.
in
MARCH/APRIL 1993
144
FEDERAL RESERVE BANK OF ST. LOUIS
145
institutional arrangements.” They measure variability by the mean absolute et-ror (MAE) of a oneperiod forecast based on the univariate multistate
Kalman Filter (MSKF). Following their approach,
table 3 presents the MAEs for inflation and real
growth for the Group of Seven countries over- successive regimes. the MSKF forecasts incorporate
both transitory and permanent shocks to the rateof-change series.”
absence of shocks to the underlying environment.
One way to shed light on this issue, following
earlier work by Bayoumi and Eichengreen, is to
identify underlying shocks to aggregate supply
and demand.~~
According to them, aggregate
supply shocks reflect shocks to the environment
and are independent of the regimne, hut aggregate
demand shocks likely reflect policy actions and
are specific to the regime.
The smallest forecast errors for inflation on average were for the Bretton Woods convertible period,
followed by the gold standard amid the floating rate
periods. The largest errors were for the interwar
period, followed by the preconvemtihle Bretton
Woods period. The most notable exception to
the pattern was the United Kingdom, where the
floating rate period exhibited the largest variability.
The approach used to calculate aggregate supply and demand shocks is an extension of the
bivariate structural vector autoregression (VAR)
methodology developed by Blanchard and Quah.~’
Following Bayoumi and Eichengreen (1992a),
I estimated a two-variable VAR on the rate of
change of the price level and output.” Restrictions on the VAR identify an aggi-egate demand
distum-bance, which is assumed to have only a
temporary effect on output and a permanent
effect on the price level, and an aggregate supply disturbance, which is assumed to have a
permanent effect on both prices and output.47
Overidentifying restrictions, namely, restrictions
that demand shocks are positively cot-related
and supply shocks are negatively correlated
with prices, can be tested by examining the
impulse response functions to the shocks.
For real growth, as for the inflation rate, the
lowest MAE, on average, occurred in the convertible Bretton Woods pem-iod. Another exception to this pattern was Japan. ‘I’he highest MAE
was again in the interwar and the preconvertible Bretton Woods period. The floating exchange
rate period, though mnore variable than the convertible Bietton Woods peiiod, was slightly less
variable than the gold standaid regime.
‘These results are quite consistent with those
of table 1. The Bretton Woods convertible
period was the most stable both in an ey
and ey ante sense. The performance of the gold
standard and the float, however, are not much
worse, at least for real growth for the float and
inflation for the gold standard.
post
Demand and Supply Disturbances
An important issue is the extent to which the
performance of atternative monetary regimes,
as ievealed by the data in the preceeding tables,
reflects the operation of the monetary regime in
constraining policy actions or the presence or
43
Meltzer and Robinson (1989) present their results for
levels, growth rates, and permanent growth rates of the
series, I present only growth rates to make the results
comparable to those in table 1.
44See Bayoumi and Eichengreen (1992a, 1992b, 1992c and
1 992d).
“See Blanchard and Ouah (1989).
‘The methodology has important limitations
that suggest that the results should be viewed
with caution. ‘I’he key limitation is that one can
easily imagine frameworks in which demand
shocks have permanent effects on output, whereas supply shocks have only temporary effects.”
I estimated supply (permanent) and demand
(temporary) shocks, using annual data for each
of the Group of Seven countries,, over alternative regimes in the period 1880—1989. The VARs
are based on three separate sets of data—1880—1913,
1919—39 and 1946—89—with the war years omitted because complete data on them were available for only four of the countries.49 The VARs
have two lags. I also did the estimation for
supply shocks are orthogonal; the tourth is that demand
shocks have only temporary effects on output, that is, that
the cumulative effect of demand shocks on the rate of
change in output must be zero.
“See Keating and f-Jye (1991).
“For results using the complete data set for these four
countries, see appendix table 1 and appendix figure I -
~~Bothvariables were rendered stationary by first differencing.
47
Specifically, four restrictions are placed on the matrix of
the shocks: two are simple normalizations, which define
the variances of the shocks to aggregate demand and
aggregate supply; the third assumes that demand and
MARCH/APRIL 1993
SlflOl 15 dO )fNV9 3A~3S3~
1V~3O3d
9t7 I.
147
aggregated pm-ice and output data for the Gi-oup of
Seven countries.~°
The overidentifying restrictions that demand
shocks be positively correlated and supply shocks
be negatively correlated with the price level are
satisfied for all countries for the two post—World
War Il regimes. But for’ the period before World
War IT, for a number of countries, including the
United States, United Kingdom, and France, they
are not. Supply shocks were positively correlated
with prices. This can be seen in the impulse
response functions displayed in figure 10. Figure 10 shows the impulse responses, to one
standard deviation shocks in aggregate supply
and aggregate demand, on output and prices for
the Group of Seven countries aggregate by regime.~’
Keating and Nyc (1991) attempted to explain this
result by possible hysteresis effects. Bayoumi and
Eichengreen (1992a) argued that the perverse
impulse response patterns for the classical gold
standard amid interwar periods reflected the
interaction of a positive aggregate demand curve
with a very steep aggregate supply curve. They
explain the positively sloped aggregate demand
curve as reflecting the effects of gold discoveries induced by the supply shock of agricultural
settlements in the United States and Australia.
These results may also reflect a limitation of the
Blanchard-Quah methodology.
Table 4 presents the standam’d deviations of
supply and demand shocks for the (;roup of
Seven countties and the Group of Seven countries taken as a whole (Group of Seven aggregate)
by regime. I also show, following Bayoumi and
Eichengreen, the weighted average of the individual country shocks.” Figum-es 11 and 12 show
the shocks for the Group of Seven aggregate
and for each of the seven countries.
“The Group of Seven aggregate income growth and inflation rate are a weighted average of the rates in the different countries. The weights for each year are the share of
each country’s nominal national income in the total income
in the Group of Seven countries, where the national
income data are converted to U.S. dollars using the actual
exchange rates.
t1The impulse response functions were calculated from
VARs run for the separate regime periods. Because the
number of observations was limited, the Bretton Woods
regime could not be split into the two subperiods shown in
Table 4 shows for the Group of Seven aggregate that the convertible Bretton Woods regime
was the most tranquil of all the regimes—neither
supply nor demand shocks dominated. It was not,
however, that much less turbulent than the succeeding float. The interwar period, unsurprisingly, shows the largest supply and demand
shocks.” Sizeable supply and demand shocks
that are two or three times greater than the
post—World War II period also characterize the
classical gold standard.”
For individual countries, the Bretton Woods
convertible period was the most stable in four
countries and the flexible exchange rate period
was the most stable in three. The difference
between the convertible Bretton Woods period
and the floating exchange rate period, however,
was not great in any country. The interwar
period as expected was the most volatile. Both
types of shocks were the largest in every country except the United Kingdom. Finally, in the
majority of countries, with the principal exceptions being the United Kimigdom arid Germany,
both supply and demand shocks were considerably greater in the gold standard period than in
the post—World War IT period.
‘rhe dispersion of demand shocks across countries, as measured by the GNP-weighted standard deviation of the individual country shocks
around the Group of Seven aggregate, reveals
very little difference between the gold standard
and the post—World War It regimes, with the
convertible Bretton Woods regime displaying
the highest degree of convergence. Dispem’sion
is much greater in the interwar period. The
dispersion of supply shocks is considerably
greater during the gold standard and the interwar periods than in amiy of the post—World
War IT regimes.
1920s and early 1930s reveal a major negative demand
shock consistent with Friedman and Schwartz’s (1963)
attribution of the onset of the Great Depression to
monetary forces. After 1931, negative supply shocks
predominate, consistent with Bernanke’s (1983) and
Bernanke and James (1 991) explanation for the severity of
the Great Depression that stresses the collapse of the
financial system.
“Though the shocks are smaller, the rankings by regime for
the weighted average of individual country shocks are similar to the G-7 aggregate.
preceding tables,
“See Bayoumi and Eichengreen (1992a).
“The results for the Group of Seven in the interwar period
(figures Ii and 12) as well as those for four countries
(appendix figure I) are similar to those reported for the
United States by Cecchetti and Karras (1992), who esti-
mate a three-variable VAR with monthly data. The late
MARCH/APRIL 1993
148
Figure 10
Impulse Response Functions of Demand and Supply Shocks on Prices (Dotted Lines) and
Output (Solid Lines), 07 Aggregate by Regimes, Annual Data, 1881-1989
Effects of Aggregate Demand Shocks, 1881-1913
Effects of Aggregate Supply Shocks, 1881-1913
0.16
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FEDERAL RESERVE BANK OF ST. LOUIS
149
Figure 10 (continued)
Impulse Response Functions of Demand and Supply Shocks on Prices (Doffed Lines)
and Output (Solid Lines), G7 Aggregate by Regimes, Annual Data, 1881-1989
Effects of Aggregate Demand Shocks, 1919-1 939
0.025
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Effects of Aggregate Supply Shocks, 191 9-1 939
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MARCH/APRIL 1993
150
Figure 10 (continued)
Impulse Response Functions of Demand and Supply Shocks on Prices (Dotted Lines)
and Output (Solid Lines), 07 Aggregate by Regimes, Annual Data, 1881 -1 989
Effects of Aggregate Demand Shocks, 1946-1 970
Effects of Aggregate Supply Shocks, 1946-1 970
FEDERAL RESERVE BANK OF ST. LOWS
151
Figure 10 (continued)
Impulse Response Functions of Demand and Supply Shocks on Prices (Dotted Lines)
and Output (Solid Lines), G7 Aggregate by Regimes, Annual Data, 1881 -1989
Effects of Aggregate Demand Shocks, 1946-1989
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MARCH/APRIL 1993
152
Figure 10 (continued)
Impulse Response Functions of Demand and Supply Shocks on Prices (Doffed Lines)
and Output (Solid Lines), 07 Aggregate by Regimes, Annual Data, 1881-1989
Effects of Aggregate Demand Shocks, 1971 -1 989
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FEDERAL RESERVE BANK OF ST. LOUIS
———4.—--——
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MARCH/APRIL 1993
154
Figure 11
Supply and Demand Shocks: 07 Aggregate, 1880-1 989, Annual Data
Percent
1880
1890
1900
1910
1920
1930
1940
1950
1960
1970
1980
1990
1950
1960
1970
1980
1990
Figure 12
Supply and Demand Shocks: 1880-1989, United States
Percent
1880
1890
1900
1910
FEDERAL RESERVE BANK OF ST. LOUIS
1920
1930
1940
155
Figure 12 (continued)
Supply and Demand Shocks: 1880-1 989, United Kingdom
Percent
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1920
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1980
1990
1950
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1980
1990
Supply and Demand Shocks: 1880-1 989, Germany
Percent
1
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1880
1890
1900
1910
1920
1930
1940
MARCH/APRIL 1993
Figure 12 (continued)
Supply and Demand Shocks: 1880-1 989, France
Percent
1880
1890
1900
1910
1920
1930
1940
1950
1960
1970
1980
1990
1940
1950
1960
1970
1980
1990
Supply and Demand Shocks: 1880-1989, Japan
Percent
1880
1890
1900
1910
FEDERAL RESERVE BANK OF ST. LOUIS
1920
1930
157
Figure 12 (Continued)
Supply and Demand Shocks: 1880-1989, Canada
Percent
1880
1890
1900
1910
1920
1930
1940
1950
1960
1970
1980
1990
1940
1950
1960
1970
1980
1990
Supply and Demand Shocks: 1880-I 989, Italy
Percent
1880
1890
1900
1910
1920
1930
MARCH/APRIL 1993
158
In sum, the evidence on supply and demand
shocks is quite similar to the measures of volatility drawn from the forecast errors using the
MSKF. The gold standard regime, as well as the
interwar period, emerges as a relatively unstable
period stressed by widely dispersed supply shocks.
fly contrast, the Bretton Woods convertible period
is the most stable, with the floating exchange
rate period not far behind.
These results raise the interesting question,
why in the past century was the classical gold
standard so durable in the face of substantial
shocks, whereas Bretton Woods was so fm-agile
in the face of the mildest shocks?
Responsiveness
to Shocks
The final piece of evidence to be calculated in
the comparison of regime performance is the
response of the price level and output to the
aggregate supply (permanent) and aggregate
demand (temporary) shocks. Evidence of a mom-c
rapid adjustment of prices and output to shocks
may help explain why one regime may have
been more durable than another.
A measure of speed of response can be gleaned
from the impulse response functions derived
from the bivariate \7AR5. In addition, as a crude
measure of response speed, which allowed easy
comparison of all seven countries (luring the
four regimes, I calculated the mean absolute lag
of the response functions.” Table 5 presents
these measures.
The response of output to both demand and
5upplv shocks for the Group of Seven aggregate
and for most of the individual countries was
markedly more rapid under the gold standard
regime than under the postwar regimes (an exception is the U.S. response to demand shocks)
and within the postwar regimes was slightly
more rapid under the Bretton Woods regime
than the floating exchange rate regime. The
response of prices to both demand and supply
shccks was considerahl more rapid during the
gold standard (and the interwar) regime than
the postwar regimes for Ihe Group of Seven
and most countries?6 Within the postwar
period, it was considerably niot-e rapid under
“The formula was PC
A c~ I PC Ac~ tor
1 to 40,
where i is the year and A c, the impulse response, calculating absolute changes because of the presence of
both positive and negative responses. This measure is
only a rough approximation because it is not possible to
calculate the standard errors.
FEDERAL RESERVE BANK OF ST. LOUIS
Bretton Woods than under the floating exchange
rate period.
Perhaps the gold standard was able to endure
the greater shocks that it faced because of both
greater price flexibility and greater factor’ mobility before World War I. Alternatively, the gold
standard was more durable than Bretton Woods
because before World War I, suffrage was limited,
central banks wem’e often privately owned and,
before Keynes, there was less understanding of
the link between monetary policy and the level
of economic activity. Hence there was less of an
incentive for the monetary authorities to pursue
full employment policies, which would threaten
adherence to convertibility.
In addition, the Bretton Woods regime was both
more stable and seemingly more flexible than
the floating exchange rate regime and yet more
fragile. This suggests that its collapse is attributable less to outside shocks to the environment
or the structum’e of the Group of Seven economy
and more to flaws in the design of the regime.
Summary
The performance of alternative international
monetary regimes suggests that the Bretton
Woods convertible regime (1959—70) was the
most stable, followed by the floating exchange
rate and the classical gold standard regimes.
The stability of forecast errors to both inflation
and growth paralleled that of the ey post data.
Limited inflation persistence—evidence for
credibility of the nominal anchor—was lowest
during the classical gold standard. Though considerably higher than under the gold standard,
persistence was less under Bretton Woods than
under the float. Under Bretton Woods the nominal anchor of the U. S. commitment to peg the
price of its currency to gold was apparently still
effective. Finally, supply shocks were greater
and less symmetric, and demand shocks were
greater under the classical gold standard than
under the post—World War II regimes. A more
rapid response of both prices and output to these
shocks also occurm-cd under the gold standard.
The question still remains why some fixed
exchange rate regimes endured longer than others
“As mentioned above, according to the overidentifying
restrictions of the Bayoumi-Eichengreen-Blanchard-Ouah
approach, supply shocks should have produced a negative
response in prices, not the positive one shown here for the
pre-World War II periods.
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160
or why the world periodically shifted between
fixed and flexible rates. The durability of the
gold standard ma he due to greater prmce flexibility and factor mobility before World War I
that allowed the world economy to respond to
shocks more rapidly. It also mat’ he due to the
absence of discm-ctionary monetary policies dedicat ed to maintaining frill employment. But the
fragility of the most stable regime, Bretton
T~%Toods in the face of mild shocks, suggests that
an undet-standing of its demise requires a closer
look at the history, institutions and rules of
behavior of alternative monetary regimes.
THE GOLD STANDARD, BRETTON
WOODS, AND THE EMS AS
COMMITMENT MECHANISMS
Perhaps the answer’ to the foregoing questions
concerning regime performance and durability
may be linked to the commitment technology of
the regime. Tn this section 1 argue that the gold
standard rule of convertibility was a credible
commitment mechanism that was crucial to its
success and that the absence of such a mechanism underlies the failure of the l3retton Woods
variant. The EMS, though not anchored to gold
convertibility, may have been successful for several years because it embodied a commitment
technology reminiscent of the gold standam’d.
However, like Bretton Woods, it was subject in
September 1992 to intolerable strains because
the commnitment mechanism proved to be not
ct-edible for many of the muembers.
tinder the classical gold standard, the mnonetarv
authorities committed themselves to fix the prices
of their currencies in terms of a fixed weight of
gold and to buy and sell gold freely in unlimited
amounts. The pledge to fix the price of a country’s currency in terms of gold represents the
basic rule of the gold standard. The fixed price
of domestic currency in terms of gold provided
a nominal anchor to the international monetary
system. tInder the Bretton Woods system only
the United States fixed the price of its currency
in terms of gold. All other convertible currencies
were pegged to the dollar. Also, under llretton
Woods, free convertibility of gold into dollars was
limited. Thus Bretton Woods was a weak variant
of the gold standard. Although the Bretton Woods
system in its convertible phase (1959—71) was
the most stable monetary regime of the past
578ee Kydland and Prescott (1977) and Barro and Gordon
(1983).
FEDERAL RESERVE BANK OF ST. LOUIS
century, it was short lived. It collapsed both
because of fatal flaws in its design (the adjustatile peg in the face of improved capital mobility
and the confidence problem associated with the
gold dollar standard) and the lack of commitment by the United States to the gold standard
convert ihil ty rule.
The Ei~iS,although not based on gold, incorporated many of the features of the Bretton
Woods adjustable peg system. Its success in
promoting the convergence of inflation rates
among its tnemnbers in the 1980s has been
linked to the presence of an effective commitment mechanism—the adherence by the German
central hank to price stability and the willingness of other members to tie their currencies to
the German mark. However, like Bret ton Woods,
it suffered serious stress in September 1992 in
the face of mnassive shocks because of the basic
incompatibility of pegged exchange rates, capital
mobility and policy autonomy. Both the center
country and the members were unwilling to
commit to a common policy.
An overview of the three regimes as embodying
the operation of credible monetary rules follows.
The Gold Standard as a Commitment
Mechanism
In the recent literature on the time inconsistency
of optimal government policy, the absence of a
credible comnmitment mechanism leads governments, in put-suing stabilization policies, to produce an inflationary outcome.57 In a closed
economy environment, once the monetary authority
has announced a given rate of monetary growth,
which the public expects it to validate, the authority then has an incentive to create a monetat-y surprise to either reduce unemployment or
capture seigniorage revenue. ‘I’he public, with
rational expectations, will come to anticipate the
authorities’ perfidy, leading to an inflationary
equilibrium. A credible precommnitmnent mechanism, h preventing the government from
cheating, can preserve long-run price stability.
The gold standard rule of maintaining a fixed
price of gold can be viewed as such a mechanism.
The gold standard i-tile can lie viewed as a form
of contingent rule or a rule with escape clauses.”
‘I’he monetary authority maintains the standard—
that is, keeps the price of the currency in terms of
gold fixed—except in the event of a well-understood
“See Grossman and Van Huyck (1988), DeKock and Grilli
(1989), and Bordo and Kydland (1992).
161
emergency, such as a major war or a financial cmisis. In wartime it may suspend gold convertibility
and issue paper money to finance its expenditures,
and it can sell debt issues in terms of the nominal
value of its currency on the understanding that debt
will eventually be paid off in gold. The rule is contingent in the sense that the public understands that
the suspension will last only for the duration of the
wartime emergency plus some period of adjustment.
It assumes that afteris’ard the government will
follow the deflationary policies necessary to resume
payments at the original parity. Following such
a rule will also allow the government to smooth
its revenue from different sources of finance, such
as taxation, borr’owing and seigniorage.5°
historical evolution itself of the gold standard.
Gold was accepted as money because of its
intrinsic value and desirable propeities. Paper
claims, developed to economize on the scarce
resources tied up in a commodity money, became
acceptable only because they were convertible into
gold. An alter-native commitment mechanism
was to guarantee gold convertibility in the constitution. This was the case for example in
Sweden before 1914, when laws pertaining to
the gold standard could be changed only by two
identical parliamentary decisions with an election in between.” Convertibility was also
enshrined in the laws of a number of gold
standard central banks.63
According to Bordo and Kydland (1992), the
gold standard contingent rule worked successfully for three come countries of the classical
gold standard: the United Kingdom, the United
States, and France. Tn all these countries the
monetary authorities adhered failhfully to the
fixed price of gold except during major wars.
During the Napoleonic War and World War I
for England, the Civil War for the United States,
and the Franco—Prussian War foi France, specie
payments were suspended, and paper money
amid debt were issued. But in each case, after
the wartime emergency had passed, policies
leading to resumption were adopted.” Indeed,
successful adherence to the rule may have enabled the belligerents to obtain access to debt
finance more easily in subsequent wars. Other
countries, such as Italy, which did not continuously maintain gold convertibility, nevertheless
adopted policies consistent with long-run convertihili ty
The gold standard originally evolved as a domestic commitment mechanism, but its enduring
fame is as an international rule. The classical
gold standard emerged as a true international
standard by 1880 following the switch by the
majority of countries from bimetallism, silver
mnonometalism and paper to gold as the basis of
their currencies.” As an international standard,
the key rule was maintenance of gold convertibility at the established par. Maintenance of a
fixed price of gold by its adherents in turn
ensured fixed exchange rates. Recent evidence
suggests that, indeed, exchange rates throughout the 1880—1914 period were characterized
by a high degree of fixity in the principal countries. Although exchange rates frequently deviated
from par, violations of the gold points amid devaluations were rare.°5
.°‘
The gold standard rule may also have been
enforced by reputational considlerations. Longrun adherence to the rule was based on the
“See Lucas and Stokey (1983) and Mankiw (1987).
°°A
case study comparing British and French finances during the Napoleonic Wars shows that Britain was able to
finance its wartime expenditures by a combination of
taxes, debt and paper money issue—to smooth revenue;
whereas France had to rely primarily on taxation. France
had to rely on a less efficient mix of finance than Britain
because she had used up her credibility by defaulting on
According to game theory literature, for an
international monetary arrangement to be effective both between countries and within them, a
time-consistent credible commitment mechanism
is required. Adherence to the gold convertibility
rule provided such a niechanism. In addition to the
who present evidence of expected appreciation of the
greenback during the American Civil War based on a
negative interest differential between bonds that were paid
in greenbacks and those paid in gold.
Giovannini (1992) finds that the variation of both
exchange rates and short-term interest rates varied within
the limits set by the gold points in the 1899—1909 period
because of the previous loss of reputation France was
unable to take advantage of the contingent aspect of the
consistent with market agents’ expectations of a credible
commitment by the four core’’ countries to the gold
standard rule in the sense of this paper.
°2SeeJonung (1984).
“See Giovannini (1993).
“See Eichengreen (1985).
bimetallic standard rule. See Bordo and White (1991).
“See Officer (1986) and Eichengreen (1985).
outstanding debt at the end of the American Revolutionary
War and by hyperinflating during the Revolution, Napoleon
ultimately returned France to the bimetallic standard
in
1803 as part of a policy to restore fiscal probity, but
61The behavior of asset prices (exchange rates and interest
rates) suggests that market agents viewed the commitment
to gold as credible. See Roll (1972) and Calomiris (1988),
MARCHIAPRIL 1993
162
reputation of the domestic gold standard and constitutional provisions that ensured domestic commitment, adherence to the international goldstandard rule nias’ have been enforced by other
mechanisms. These include improved access to
international capital markets, the operation of
the rules of the game, and the hegemonic
power of England.
Support for the intertiational gold standat-d
likely grew because it provided improved access
to the intet-national capital markets of the core
countries. Countries were eager to adhere to
the standard because thex’ believed that gold
convertibility would he a signal to credit (fl~sof
sound government finance and the futut-e ahilits’ to service debt.”°
This was the case both for developing countries
seeking access to long-term capital, such as
Austria-I-lungarv and Latin Amet-ica, and fotcountries seeking short-term loans, such as
.lapan which financed the Russo-Japanese war
of 1905—06 with foreign loans seven years after
joining the gold standard.°~Once on the gold
standard, these countries feared the consequences
of suspension.” ‘That England, the most successful country of the nineteenth century, as well
as other progressive countries were on the gold
standard was probably a powerful argument
br ~oining.’°
The opera tion of the rules of the game,
wheretiv the monetary authorities were supposed to alter the discount i-ate to speed up the
adjust ment to a change in external halance, may
also have heen an important half of the commitment mechanism to the international goldl
standard rule. To the extent the rules were followed and amljustment facilitated, the commitmnenl to convertibility was strengthened and
conditions conducive to ahandonment wem-e
lessened.
Evidence on the opel-ation of the rules of the
game questions their validity. Bloomfield (1 959)
in a classic study, showed that, with the principal
exception of F.ngland, the rules were frequently
violated in the sense that discount rates were
SeA
case study of Canada during the Great Depression pro-
vides evidence for the importance of the credible commitment mechanism of adherence to gold. Canada
suspended the gold standard in 1929 but did not allow the
Canadian dollar to depreciate nor the price level to rise for
two years. Canada did not take advantage of the suspension to emerge from the depression because of concern
for its credibility with foreign lenders. See Bordo and Redish (1990).
675ee Yeager (1984), Fishlow (1989) and Hayashi (1989).
FEDERAL RESERVE BANK OF ST. LOUIS
not always changed in the required direction
(or by sufficient amounts) and in the sense that
changes in dotnestic credit were offen negatively corm’elated with changes in gold reserves.
In addition, a number of countries used gold
devices—practices to prevent gold outflows.
For the major countries, however (at least
before 1914) such policies were riot used extensively enough to threaten the convertibility to
gold—evidence of commitment to fiie l-ule.”
Moreover, as McKinnon (1992) argues, to the
extent that monetary authorities followed Bagehot’s rule and prevented a financial crisis while
seemingly violating the rules of the game, the
commitment to the gold standard in the long
run may have been strengthened.
An additional enforcement mnechanism for the
in t erna tiomal gold static] at-cl m-ule may have been
the hegenionic power of Englamid, the most
important golml standard count rvi’ A Iiersistent
1 heme in t lie literature on the international gold
stanmlard is that the classical gold standard of
1880 to 1914 was a British-managed standard.~
Because London was the center for the world’s
principal gold, comnmoclities and capital mam-kets,
tiecause of the extensive outstanding sterlingdenominated assets, and because many countm-ies
substituted sterling for gold as an international
reserve currency, some argue that the Batik of
England, by manipula t big its hank rate, could
attract whatever gold it needed and, fm-f hermore, that other central banks would adjust
their discount rates accordingly. ‘l’hus the Bank
of England could exert a powerful influence on
the money supplies and p-ic levels of other
gold standai-d countries.
The evidence suggests that the Hank did have
sonic influence on other European cetitmal hanks.~~
Lichengreen (1987) treats the Bank of England
as one engaged in a leadership role in a Stackelberg
strategic game with other central banks as followers. The other central banks accepted a
passive role because they benefited from using
stem-Inig as a reserve asset Acco mcling to tliis
interpm-etation, the gold standard rule mas’
-
“See
“See
70See
7mSee
72See
“See
Eichengreen (1989a) and Fishtow (1987 and 1989).
Friedman (1990) and Gallarotti (1991).
Schwartz (1984).
Eichengreen (1989b).
Bordo (1984).
Lindert (1969).
163
have been enforced by the Bank of England.7.m
‘thus the monetary authorities of many countries may have been constrained from following
indlependent discretionary policies that would
have threatened adherence to the gold standlard
rule.
Indeed according to Giovannini (1989), the gold
standam-dl ivas an asymmetric system. England
was the center country. It used its monetary
policy (hank t-ate) to maintain gold convertibility. Other countries accepted the dictates
of fixed pam-ities and allowed their money supplies to respond passively. His regressions
suppoi-t tins view—the French and Germnan
central banks adapfed their domestic policies
to external conditions, whereas the British
did not.
The benefits to England as leader of the gold
standard—from seigniorage earned on foreignheld sterling balances to returns to financial
institutions generated b its central position in
the goldl sta ndam-d and to access to international
capital markets in wartime—were substantial
enough to make the costs of not following the
rule ex tt-emely high.
‘The classical gold standard ended in the face
of the massive shocks of World War ~ ‘Ihe
gold exchange standard, which prevailed for
only a few years frotii the mid-1920s to the
Great Depression, was ami attempt to restore the
beneficial features of the classical gold standard
while allowing a greater iole for domestic stahilization policy. This in tum-n cm-eated a growing
conflict between adherence to the rule and discretion. If also attempted to economize on gold
reserves by restricting its use to central banks
and by encoui-aging the use of foreign exchange
as a substitute. As is well known, the goldl exchange standard suffered from a number of
fatal flaws.” These includle the use of two
reserve currencies (the pound and the dollar),
the absence of leadem-ship liv a hegemonic
p°~ver,the failure of cooperation between the
74
According to Eichengreen (1989a), the Bank of England’s
ability to ensure convertibility was aided by the cooperation of other central banks. In addition, as mentioned
above, belief based on past performance that England
attached highest priority to convertibility encouraged
stabilizing private capital movements in times of threats to
convertibility, such as in 1890 and 1907,
“The standard deviations of both supply and demand
shocks during World War I for the countries for which we
key members (England, France and the United
States), and the unwillingness of its two strongest
members, the United States and France, to follow the rules of the game. Instead they exerted
deflationary pressure on the rest of the world
by persistent sterilization of balance-of-payment
surpluses. The gold exchange standard collapsed,
but according to F’riedmnan arid Schwartz, Temin,
andl Eichengreen, not before transmitting deflation and depression across the world.~~
The Bretton Woods International
Monetary System
The planmnng that led to Bretton Woods aimed
to prevent the chaos of the interwar period.”
The perceived ills to he prevented included (1)
floating exchange rates that were condemned as
subject to cTestabilizing speculation; (2) a gold
exchange standard that was vulnem-able to problems of adjustment, liquidity amid confidence,
which enforced the international ti-ansrnissior
of deflation in the early 1 930s; and (3) the
resort to heggar-thv-neighhor devaluations,
trade rest rictions, exchange controls and bilateralism after 1933. ‘To lirevent these ills, the case
for an adjustable peg system was made by
Keynes, White, Nurkse and others.” The new
system would combine the favorable features of
the fixed exchange rate gold standard—stability
of exchange rates—amid of the flexible exchange
rate standard—monetary and fiscal independtence.
Both Keynes, leading the British negotiating team
at Bretton Woodls, and White, leading the Amneri-
can team at Bretton Woods, planned tin adjustable
peg system to lie coordinated by an international
monetary agency. The Keynes plan gave the International Cum-rency Union substantially mnome
reserves amid poii’er than the United Nations Stabilization Fund proposedl by White, hut both institutions would have hadl considerable control ovem- the
domestic financial policy of the members.
The Ilmitisli plan contained more domestic policy
autonomy than dlid the U.S. plan, whereas the
“See Kindleberger (1973), Temin (1989), and Eichengreen
(1992c).
“See Friedman and Schwartz (1963), Temin (1989) and
Eichengreen (1 992c).
“This section draws heavily on Bordo (1992).
“See Bordo (1993).
have continuous data were two to three times as great as
during the classical gold standard, See appendix table 1
and figure I
-
MARCH/APRIL 1993
164
American plan put more emphasis on exchange
rate stability. Neither architect was in favor of a
8
rule-based system. °The British were most concerned with preventing the deflation of the 1930s,
which they attributed to the constraint of the gold
standard m’ule and to deflationary U.S. monetary pol-
icies. ‘thus they wanted an expansionary system.
The American plan was closer to the gold
standard rule in that it stressed the fixity of
exchange mates. It did not explicitly mention the
importance of rules as a cm-edible commitment
mechanism, but there were to be strict regulations on the linkage between UNITAS (the proposed international reserve account) and gold.
Members, in the event of a fundamnental disequilibrium, could change their parities only
with approval from a three-quarters majom’ity of
all members of the fund.”
‘the Articles of Agreement of the International
Monetary Fund incorporated elements of both the
Keynes and White plans, although in the end, U.S.
concerns predominated.” The main points of the
articles were: the creation of the par value system;
mnultilateral payments; the use of the fund’s
resources; its powers; and its organization.
The Par Value System
Article TV det’ined the numeraire of the international monetary system as either gold om the tJ.S.
dollam of the weight and fineness on July 1, 1944.
All members were urged to declare a par value
and maintain it within a 1 percent margin on
either side of parity. Pam-ity could be changed in
the event of a fundamental payments disequilibrium at the decision of the member, after consultation with other fund members. ‘F he fund
would not, however, reject the change if it was
not more than 10 percent; if the change was
more than 10 percent, the fund would decide
80
1n the sense of a commitment mechanism to prevent the
time consistency problem. According to Meltzer (1988) and
Moggridge (I 986), Keynes had a strong preference for
rules over discretion, interpreting rules in the traditional
sense,
tm1
See Giovannini (1993).
12Am the same time as the Articles of Agreement for the
International Monetary Fund were signed, the International
Bank for Reconstruction and Development (the World
Bank) was established. The Charter of the International
Trade Organization (ITO) was drafted and si9ned in 1947
but never ratified. It was succeeded by the General Agreement for Tariffs and Trade (GATT) originally negotiated in
Geneva in 1947 as an interim institution until the ITO
came into force,
FEDERAL RESERVE BANK OF ST. LOUIS
within 72 hours. Unauthorized changes in the
exchange rate could make members ineligible to
use the fund’s resources, and if a member continued
to make unauthorized changes, it could be expelled
from the fund. A uniform change in par value of
all currencies (in terms of gold) required approval
by a majonity of all voting fund members arid
also had to be approved by every member with
10 percent or more of the total quota.
Multilateral Payments
Members were supposed to make their currencies convertible for cut-rent account transactions
(Art. VIII), but capital controls were permitted
(Art. VI.3). They were also to avoid discriminatory currency and multiple curency arrangements. Countries could avoid declaring their
currencies convertible, however, by invoking
Art. XIV, which allowed a three-year transition
period after establishmnent of the fund. During
the transition period, existing exchange controls
could be maintained.”
The Fund’s Resources
As under the White plan, members could
obtain resources fromn the fund to help finance
short- or medium-term payments disequilihria.
The total fund, contributed by mnembem-s quotas
(25 pci-cent in gold amid 75 percent in currencies)
was set at $8.8 billion. It could he raised every
five yeams if the mnajoritv of members wanted to
do so. The fumid set a number of conditions on
the use of its resources by deficit countries to
prevent it fromn accumnulating soft currencies
and froni depleting its holdings of harder cur-
rencies.8” It also established requirements and
conditions fom m-epurchase (repayment of a loan),
imicluding giving the fund the right to decide the
currency in which repurchase would be made.
“Under Art, XIV, three years after March 1, 1947, the IMF
would begin reporting on the countries with existing controls, two years later it woutd begin consulting with individual members and advising them on policies to restore
payments equilibrium and convertibility. Countries that did
not make satisfactory progress would be censured and
ultimately asked to leave the fund, In fact, the fund always
accepted the member’s reason for remaining under Art.
XIV,
~Members could draw on their quotas without condition.
Beyond that, referred to later as the credit tranches.
although not spelled out in the articles, increasingly more
exacting conditions were required.
165
In the case of countries prone to running large
surpluses, the scarce currency clause (Art. VII)
would come into play. If the fund’s holdings of a
currency wet-c insufficient to satisfy the demand
for it by other members, it could declare it scarce
and then urge members to ration its use by dis-
criminatory exchange controls.
The Powers of the Fund
The fund had considerably less discretionary
power over the domestic policies of its members
than either of the architects wanted, but it still
had power to influence the international monetary system strongly. These powers included its
authority to approve or reject changes in parity;
the use of multiple exchange rates and other
disctiminatory practices; the conditionality implicit
in members’ access to the credit tranches of
their quotas, which was made explicit by 1952; its
authomity to declare currencies scat-ce; its authority
to declare members ineligible to use its resources
(used against France in 1948 following an unapproved devaluation); and its ultimate authority
to expel members.” The fund also had considerable power as the premier international monetary organization in consulting and cooperating
with national and other international monetary
authorities.
Organization
The fund was to be governed by a board of
governors appointed by the members. The board
would make the major policy decisions, such as
approving a change in parity. Operations of the
fund were to be directed by executive directors
appointed by the members arid a managing director selected by the executive dinectors. Major
changes such as a uniform change in the par
value of all currencies or the second amendment to the articles, which created the special
drawing right (SDR), would require a majority
vote by the members. The number of votes in
turn was tied to the size of each member’s quota)
which was determined by its economic size.
i’hough the articles could not be interpreted
strictly as a retunn to the gold standard rule of
the fixed price of gold with free convertibility,
“See Diz (1984) for a discussion of conditionality impticit in
members’ access to the credit tranches of their quotas.
“See, for example, Tew (1988), Scammell (1976) and
Veager (1976). For Williamson (I985b) it was a comprehensive set of rules for assigning macroeconomic pol-
the fixed price of gold at $35 per ounce, which
the U.S. was to maintain, represented the nominal anchor of the system. Members were required
to maintain parity of their exchange rates in
terms of dollars (or gold). Also, like the gold
standard, it was a rule with an escape clause.
Members at their initiative could alter their parities in the event of a fundamental disequilibrium.
The architects never spelled out exactly how
the system was supposed to work. Subsequent
writers, however, have suggested a number of
salient features.” First, curm-encies were treated
as equal in the articles. This meant that in theory
each country was required to maintain its par
value by intervening in the currency of every
other country—a practice that would have worked
at cross purposes. In fact, because the United
States was the only country that pegged its currency in terms of gold (bought and sold gold),
all other countries would fix their parities in
terms of dollars and would intervene to monitor
their exchange rates within 1 percent of parity
with the dollar.
Second, countries would use their international
reserves or draw resources from the fund to finance
payments deficits. In the case of surpluses, countries would tempot-arily build up reserves or repurchase their currencies from the fund. In the
event of medium-tem-ni disequilibria, they would use
monetary and fiscal policy to alter aggregate
demand. In the event of a fundamental disequilibrium, which was never defined but presumably
reflected either some permanent structural shock
or sustained inflation, a member was supposed to
alter parity by an amount sufficient to restore external equilibrium.
Third, capital controls wet-c permitted to prevent
destabilizing speculation from forcing members to
alter their parities prematurely or unintentionally.
THE HISTORY OF BRETTON
WOODS: PRE-CONVERTIBILITY
1946—58
The international monetary system that began
after World War TI was far different front the
system that the architects of Bretton Woods
envisioned. ‘The transition period fmom war to
icies—exchange rates to medium-run external balance,
monetary and fiscal pohcy to short-run internal batance
and international reserves—to provide a buffer to allow
short-run departures from external balance,
MARCH/APRIL 1993
166
peace was much longer and more painful than
anticipated. Frill convertibilit of the major
industrial countries was not achieved until the
end of 1958, although the system had started
functioning normally hx’ 1955. Two interrelated
problems dominated the fit-st postwar decade:
hilateralismn and the dollar shortage.
Bilateralism
The legacy of Wot-ld War 11 for virtually every
country except the United States was one of
pervasive exchange controls and controls on
trade. No mnajor currency except the dollar was
convertible.” Under Art. XIV of the Bretton
Woods agreement, countries could continue to
use exchange controls for- an indefinite tranisition period aftem- the establishment of the International Monetary Fund (IME) on March 1, 1947.
In conjunction with exchange controls, every
country negotiated a series of bilateral payments agreements with each of its trading parttiers. ‘t’he rationale For the continued use of
controls and bilateralism was a shortage of
international reserves. After the war, the economies of Europe and Asia were devastated. To
produce the exports needed to generate foreign
exchange, industries requiled new and improved
capital. There was an acute shortage of key
imports, both foodstuffs to maintain living
standards and raw materials and capital equipment. Controls allocated the scam-ce reserves.
inflows continued to finance wartime expenditures 1w the allies. At the end of World War II,
gold and dollar reserves in Eum-ope and Japan
were depleted. Europe ran a massive cLtrrent
account deficit, reflecting the demand for essential imports and the reduced capacity’ of the
export industties. The Organization for European Economic Cooperation (OEEC) deficit,
aggravated by the had winter of 1946—47,
reached a high of $9 billion in 1947. The OEEC
deficit equaled the aniount of the U.S. current
account surplus, which was large because the
United States) as the only majom’ industrial country operating at full capacity, supplied the
needed iniports. The dollar shortage was likely
aggravated by overvalued official parities set by
the major European industrial countries at the
end of 1946.88
By the mid—1950s both problems had been
solved. The currencies of western Europe were
virtually convertible by 1955 and their current
accounts were generally in surplus. The key
developments in this progmess were the Marshall Plan and the European Payments Union.
The Marshall Plan
B~the end of World War II, the United States
field two-thirds of the world’s monetary gold
stock (see figure 131. ‘the gold avalanche in the
United States in the 1930s was the consequence
of both the dollar devaluation in 1934, when
the Roosevelt administration raised the price of
gold fromn $20.67 per ounce to $35.00, and capital flight from Europe. During the war, gold
The Marshall Plan funneled approximately $13
billion in aid (grants and loans) to western Europe
between 1948 and 1952.” ‘The plan required
the recipients to cooperate in the liberalization
of trade and payments. Consequently, the OEEC
was established in April 1948. It presided over
the allocation of aid to mnemhers based on the
size of their current account deficits. U.S. aid
was to pay for essential imports and to provide
international reserves. Each recipient government provided matching funds in local curt-encv
to be used for investment in the productive
capacity of industry, agriculture and infrastructure. Each country also had a delegation of U.S.
administrators that advised the host government on the spending of its counterpart funds.
“Under the classical gold standard, convertibility meant the
ability of a private individual to freely convert a unit of any
national currency into gold at the official fixed price. A
the parity fixed (within the 1 percent margin) and the
United States freely buys and sells gold to maintain the
The Dollar Shortage
suspension of convertibility meant that the exchange rate
between gold and national currency became flexible but
the individual could still freely transact in either asset. See
Triffin (1960). By the eve of World War II, convertibility
referred to the ability of a private individual to freely make
and receive payments in international transactions in terms
of the currency of another country. Under Bretton Woods,
convertibility meant the freedom for individuals to engage
in current account transactions without being subject to
exchange controls. Tew (1988) defines this as market convertibility and distinguishes it from official convertibility
whereby the monetary authorities of each country freely
FEDERAL RESERVE BANK OF ST. LOUIS
buy and sell foreign exchange (primarily dollars) to keep
fixed price of $35 an ounce (within the 1 percent margin).
He refers to both market and official convertibility as Bretton Woods convertibility. See also McKinnon (1979) and
Black (1987).
“See Triffin (1957).
“See Milward (1984) and Hoffman and Maier (1984).
167
Figure 13
Monetary Gold and Dollar Holdings: the United States and the Rest of the World,
1945-1971 Billions of U.S. dollars
605040-
—
U.S. Monetary Gold Stock
—
External Dollar Liabilities
—
External Dollar Liabilities held by Monetary Authorties
—
Rest of the World Monetary Gold Stock
3020—
10—
I
‘I’,
1945
47
49
I
I
51
53
I
I
I
55
The plan encouraged the liberalization of intraEuropean tmade and payments Liv gt-anting aid
to countries that extended bilateral credits to
other mem’nhers. Finally, the European Payments
Union (EPU) was established in 1950, under the
auspices of the OEEC, to simplify bilateral clearing and pave the tvav to mu ltilateralism
-
13v 1952, in part thanks to the Marshall Plan,
the OEEC countries had achieved a 39 percent
increase in industrial prodriction a doubling of
exports, an increase in imports liv one-third and
a current account surplus.’”’
-
The European Payments Union
and the Return to Convertibility
It took 12 years from the declaration of official par values by 32 nations in Deceniher 1 946
to achieve convertihilitv for current transactions
liv the major industrial countries, as specified
liv the Btettoti Woods Articles. ‘the Western
Eur-opean miations tried sevem-al schemes to facilitate the payments process before estatilishing
the EPU in 1950.9!
I
I
57
59
I
T
I
61
53
I
I
65
I
67
m
69
71
bank clearinghouse. At the end of each month,
each member would clear its net debit om cr’edit
position (against all other members) with the
EPU (the BIS actitig as its agent). The unit of
account for these clearings was the U.S. dollar.
The EPU also provided extensive credit lines.
The EPU was highly successful in reducing the
volume of pavnients transactions and provided
the background for- the gradual liberalization of
~iayments so that by 1953 comniercial banks were
able to engage in multicurrencv arbitrage.” On
December 27, 1958, eight countries declared
their currencies convertible for curm’ent account
ramis actions.
The miiovement to convertibility was aided by
the devaluations of 1949. F’ollowing a speculative run on the pound in the summer of 1949,
the British, 24 hours after informing the IMF’,
devalued the pound by 30.5 percent. Shortly
thereafter, 23 countries reduced their parities
by similar magnitudes in most cases.
The EPU, established Septemnbei- 19, 1950, by
the OEEC countries, initially was to i-un for two
veam’s, renewable thereafter omi a yearly basis.
It followed the basic prh~cipleof a commercial
The devaluations of 1949 were important for
the Brettomi Woods system for two reasons. First,
they, along with the Marshall Plan aid, helped
move the European countries from a current
account deficit to a surplus, a movement important to the eventual restoration of comivem-tibility.
Second, they revealed a basic weakness of the
“Solomon (1976).
‘tTew (1988) and Veager (1976).
“Kaplan and Schleiminger (1989),
MARCH/APRIL 1993
168
adjustable peg arrangement—the one-way option
of speculation against parity. By allowing
changes in parity only in the event of a fundamental disequilibrium, the Bretton Woods system encouraged the monetary authorities to
delay adjustment until they were sure it was
necessary. By that time, speculators also would
be sure and they would take a position from
which they could not lose. If the currency is
devalued, they win and if it is not, they just lose
the interest (if any) on the speculative funds.”
The crisis associated with the 1949 sterling
devaluation in turn created further resistance
by monetary authorities to changes in parity,
which ultimately changed the nature of the
international monetary system from the adjustable peg intended by the Bretton Woods Articles
to a fixed rate megime.
Other developments in the preconvertiblity
period included the decline of sterling as a
reserve asset and the reduced prestige of the
IMF. The 1MF by intention was not equipped to
deal with the postwar reconstruction problem.
Although some limited drawings occurred
before 1952, most of the structural balance of
payments assistance in this period was provided
by the Marshall Plan and other U.S. assistance,
including the Anglo-American Loan of 1946. The
consequence of this development is that other
institutions such as the BIS, the agent for the
EPLJ, emerged as competing sources of international monetary authority.’~
The fund’s prestige was dealt a severe blow
by three events in the preconvertibility period.
‘I’lie first event ivas the French devaluation of
January 1948, which created a multiple exchange
rate system. The fund censured France for
creating broken cross rates between the dollar
and the poutid. France was denied access to the
fund’s resout-ces until 1952. France ended the
broken cross rates in October 1948 and adopted
a unified rate in the devaluation of 1949. Since
France had access to the Marshall Plan, the fund’s
actions had little effect. The second event was the
sterling devaluation of September 194~,when
the fund, instead of being actively involved in
consultation, was given 24 hours perfunctory
notice. The third event was the decision by
Canada to float its currency in September 1950.
T’hough the futid was highly critical of the action,
it was unable to prevent it. ‘I’he Canadian dollar
floated successfully until 1961.
“See Friedman (1953).
“See Mundell (1969).
FEDERAL RESERVE BANK OF ST. LOUIS
Finally, the fund’s resources were inadequate
to solve the emerging liquidity problem of the
1960s. The difference between the required
growth of international reserves (to finance the
growth of real (iutput and trade and to avoid
deflation) and the growth in the world’s monetary gold stock was met largely by an increase
in official holdings of U.S. dollars resulting fi-om
growing U.S. balance-of-payments deficits. By
the time full convertibility was achieved, the
U.S. dollar was serving the buffer function
intended by the Bretton Woods Articles for the
fund’s resources.”
THE HISTORY OF BRETTON
WOODS: THE HEYDAY OF
BRETTON WOODS 1959-1967
With current account convertibility established
by the western European industrial nations at the
end of December 1958, the full-blown Bretton
Woods system was in operation. Each member
intervened in the foreign exchange market,
either buying or selling dollars, to maintain its
parity within the prescribed 1 percent margins.
The U.S. Treasury in turn pegged the price of
the dollar at $35 per ounce by freely buying
and selling gold. Thus each currency was
anchored to the dollar and indirectly to gold.
Triangular arbitrage kept all cross r-ates within
a band of 2 percent on either side of parity.
Through much of this period, capital controls
prevailed in most countries except the United
States in one form or another, although by the
mid-1960s their use declined while increasing in
the United States.
The system that operated in the next decade
turned out to be quite different from what the
architects had in mind. First, itistead of a system
of equal currencies, it evolved into a variant of
the gold exchange standard—the gold-dollar system. Initially, it was a gold exchange standard
with two key currencies, the dollar and the
pound. But the role of the pound as key currency declined steadily throughout the 1960s.
Concurrently with the decline of sterling was
the rise in the dollar as a key currency. Use of
the dollar as both a private and official international money increased dramatically in the
1950s amid continued into the 1960s. With full
convertibility, the dollar’s fundamental role as
“See Mundell (1969).
169
intervention currency led to its use as international reserves. This was aidled by stable and
low monetary growth and relatively low inflation (before 1965). See figure 1 and table 1.
‘the gold exchange standard evolved in the
post—World War tt period for the same reasons
it did in the 1920s—to economize on non-interesthearing gold reserves. Ry the late 1950s, the growth
of the world’s monetary gold stock was insufficient to finance the growth of world real output
and trade.” The other intended source of international liquidity—the resources of the fund—
was also insufficient.
‘The second important difference between the
convertible Bretton Woods system and the intentions of the Bret ton Woods Articles was the evolution of the adjustable peg system into a virtual
fixed exchange rate system. Between 1949 and
1967, vet-y few changes in parities of the Group
of Ten countries occurred.’~The only exceptions were the Canadian float in 1950, devaluations by France in 1957 and 1958, and minor
revaluations by Germany and the Netherlands in
1961. The adjustable peg system became tess
adjustable because the monetary authorities,
based on the 1949 expeiience, were unwilling
to accept the risks associated with discrete
changes in parities—loss of prestige, the likelihood that others would follow and the pressure
(if speculative capital flows if even a hint of a
change in parity were present.
As the system evolved into a fixed exchange
rate gold dollat- standard, the three key problems of the interwar system reemerged: adjustment, liquidity and confidence. These problems
dominated academic and policy discussions during the period.
The Adjustment Problem
The adjustment issue focused on how to achieve
it in a world with capital controls, fixed exchange
rates and domestic policy autonomy. Various policy measures were proposed to aid adjustment,
including income policies, rescue packages, capital and trade controls, a mix of monetary and
fiscal policy, and the injection of new liquidity.
Of particular interest during the period was
asymmetry in adjustment betiveen deficit countries
like the tjnited Kingdom and surplus countries
like Germany and between the United States as
the reserve currency country and rest of the world.
Both the United Kingdom amid Germany ran
the gauntlet between concern over external
convertibility and domestic stability. The United
Kingdom alternated between expansionary policy that led to balance-of-payments deficits and
austerity. Germany alternated between a balanceof-payments surplus that led to inflation and
austerity.
The United States had an official settlements
balance-of-payments deficit in 1958 that persisted, with the notable exception of 1968—69,
until the end of Bm’etton Woods. See figui-e 14.
With the exception of 1959, however, the
United States had a current account surplus
until 1970. The balance-of-payments deficit
under Bretton Woods arose because capital outflows exceeded the current account surplus. In
the early postwar years, the outflow consisted
largely of foreign aid. By the end of the 1950s,
private long-term investment abroad (mainly
direct investment) exceeded military expenditures abroad and other official transfers.”
The balance-of-payments deficit was perceived
as a problem by the U.S. monetary authorities
because of its effect on confidence. As official
dollar liabilities held abroad mounted ivith successive deficits, the likelihood increased that
these dollars would be converted into gold and
eventually the U.S. monetary gold stock would
reach a point low enough to triggel a run.
tndeed the U.S. monetary gold stock by 1959
equalled total external dollar liabilities and the
rest of the world’s monetary gold stock exceeded
that of the United States. See figure 13. By 1964
official dollar liabilities held by foreign monetary author-ities exceeded the U.S. monetary
gold stock.
A second reason the balance-of-payments
deficit was perceived as a problem was the dollar’s role in providing liquidity to the rest of the
world. Elimination of the U.S. deficit would create a i-vorldwide liquidity shortage.
“See Triffin (1960) and Gilbert (1968).
“The Group of Ten countries were Belgium, Canada,
France, West Germany, Italy, Japan, the Netherlands,
Sweden, United Kingdom, and the United States. Switzerland was an associate member.
“See Eichengreen (1991c).
MARCH/APRIL 1993
170
Figure 14
Balance of Payments: United States, 1950-1 971 Millions of U.S. dollars
8,0004,000
-
0-
ii
-4,000-8,000
-
-12,000-16,000-20,000- —r
195051 52
Short-Term Capital
—
Long-Term Capital
—
I
I
I
I
I
Current Account
Change in Reserves
I
I
I
I
I
I
I
53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71
For the Europeans, the U.S. balance-ofpayments deficit was a problem for different
reasons. First, as the reserve currency country,
the United States did not have to adjust its
domestic economy to the balance of payments.
As a matter of routine, the Federal Reserve
automatically sterilized dollar outflows. The
asymmetry in adjustment was resented. The
Germans viewed the situation as the United
States exporting inflation to surplus countries
through its deficits. Their remedy was for the
United States (and the United Kingdon) to pursue contractionary monetary and fiscal policy.”
In fact, U.S. inflation was less (on a GNPweighted average basis) than that of the rest of
the Group of Seven countries before 1968. See
figures 1 and 15. The French resented U.S.
financial dominance and the seigniorage they
believed the United States eained on its outstanding liabilities. Acting on this perception,
the French in 1965 began to systematically convert outstanding dollar liabilities into gold. The
French solution to the dollar problem was to
double the price of gold—the amount by which
“See Emminger (1967).
“See Rueff (1967).
1
”See Despres, Kindleberger and Salant (1966).
FEDERAL RESERVE BANK OF ST. LOUIS
the real price of gold had declined since 1934.
The capital gains earned on the revaluation of
the world’s monetary gold reserves would be
sufficient to retire the outstanding dollar (and
sterling) balances. Once the United States
returned to balance-of-payments equilibrium,
the world could return to a fully functioning
classical gold standard.’”
Some economists argued that the U.S. balanceof-payments deficit was not really a problem.
The rest of the world held dollars voluntarily
because of their valuable service flow; the
deficit was demand determined.”
The policy response of the U.S. monetary
authom-ities was fourfold: to impose controls on
capital exports; to institute measures to improve
the balance of trade; to alter the monetary fiscal policy mix; and to employ measures to stem
the conversion of outstanding dollais into gold.
During this period, var-ious solutions to the
U.S. adjustment problem were proposed: provision of an alternative international reserve
171
Figure IS
Inflation Rates in the United States, Gland G7 Excluding the United States, 1951 -1 973
Percent
14
12
10
8
6
4
2
0
195152535455565158596061626364656667686970717273
media to increase world liquidity; an increase in
The Liquidity Problem
the price of gold, either unilaterally, which would
devalue the dollar against other currencies, or by
a uniform change in all parities as under Att. IV;
and others, evolved from a shortfall of mone-
and increased exchange rate flexibility.b0z
The U.S. balance-of-payments policies were in
the main ineffective.” As long as the United
States maintained relatively stable prices, as it
did before 1965, the system could be preserved
The liquidity problem, posed by Rohert ‘I’riffin
tary gold beginning in the late 1950s. The real
price of gold had been falling since World War
II and would eventually reduce world gold
production. This happened in the early 1950s
hut was offset by new sources of production.
Gold production declined again in 1966. More-
solutions advocated at the time of an increase in
the price of gold and an increase in world liquidity
by creation of an artificial reserve asset would
not have permanently eradicated the problem. ‘°~
over, the falling real price would stimulate private demand for gold and it seemed unlikely
that Russian gold sales would make up much of
the shotifail. The prospect of the world nionetary gold stock growing enough to finance the
growth of world real output and the value of
trade (without deflation) seemed dim. As can
clearly be seen in figure 16 for the Group of
“The official view, which was strongly opposed to increased
exchange rate flexibility, is in marked contrast to the academic view, which by the end of the decade was solidly in
favor of increased flexibility, as evident at the famous Burgenstock Conference. See HaIm (1970) and also Johnson
(1972a).
“See Mettzer (1991).
4
‘° Evenat a higher gold price, world gold production would
eventually be inadequate to produce long-run price stability. In the long-run, when account is taken of gold as a
durable exhaustible resource, deflation is inevitable. See
Bordo and ElIson (1985). Moreover, an increase in world
liquidity by an artificial reserve asset, if convertible into
gold, would not remove the basic convertibility problem.
See McKinnon (1988). Finally as Townsend (1977), Salant
(1983) and Buiter (1989) point out, the gold exchange
standard as a type of commodity stabilization scheme is
bound to collapse in the face of unforeseen shocks, See
Garber (1993). According to Meltzer (1991), however, a 50
percent gold revaluation would have succeeded in preserving the Bretton Woods system well into the 1970s had the
United States not followed an inflationary policy in the late
1960s.
for a number of years. ‘the real pt-oblem was
that of the gold exchange standard—a convet-ti-
bility crisis was ultimately inevitable. ‘The twin
MARCH/APR1L 1993
172
Figure 16
The Growth of the Monetary Gold Stock, the Growth in International Reserves and the
Growth of the Volume of Real Trade and Real Income, G7, 1951-1973
Percent
50
45
40
35
30
25
20
15
10
5
0
-5
Change in Monetary Gold Stock
-10
I
I
I
I
I
195152 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71
Seven countries, this was the case. A large gap
opened in 1958 between the gr-owth of output
and the volume of trade and the growth of
Group of Seven gold reserves. As can he seen in
figure 17, the shortfall for the Group of Seven
countries, excluding the United Slates, was made
up by a drain on the U.S. monetary gold
reserves until 1966.
As Triffin (1960) pointed out, dollars supplied
by the U.S. deficit could not be a permanent
solution to the impending gold shortage because
with continuous deficits, U.S. nionetary gold
reserves would decline both absolutely and relatively to outstanding dollar liabilities until an
eventual convertibility crisis. Should the 1.1.5.
monetary authorities close the deficit hefot-e
such a crisis, however, it would create a massive shortage of international liquidity and the
prospect of wot-Id deflation. New sources of
liquidity were required, answered by the creation of the special drawing rights in 1967. B)’
the tine SDRs were injected into the system in
1970, however, they exacerbated workhvide
inflation “Although according to Meltzer (1991), there is little evidence in asset markets through the 1960s of a growing
loss of confidence in the dollar. Real interest rates did not
FEDERAL RESERVE BANK OF ST. LOUIS
72 73
The Confidence Problem
The perceived key problem of the convertible
Bret ton Woods period was the confidence crisis
5
for the dollar.b0 As argued by ‘I’riffin (1960),
Kenen (1960) and Gilbert (1968), the gold-dollar
system that evolved after 1959 was bound to be
dynamically unstable if the growth of the world
monetary gold stock was insufficient to finance
the growth of world output and trade and to
prevent the U.S. monetary gold stock from
declining relative to outstanding U.S. dollar liabilities. ‘I’he pressure on the U.S. tnonetary gold
stock would continue, as growth of the world
monetary gold stock declined relative to the
growth of world output and trade and as the
world substituted dollars for gold, until it triggered a confidence crisis that led to the collapse
of the system, as occurred in 1931. At the same
time, however, as feat-s over U.S. gold convertihility threatened the dynamic stability of the
Bretton Woods system, gold still served two
positive roles.
Gold was the numeraire of the system; all
rise significantly relative to trade weighted real interest
rates. Nor did the gold and foreign exchange markets suggest a flight from the dollar.
173
Figure 17
The Growth of the Monetary Gold Stock, the Growth in International Reserves and the
Growth of the Volume of Real Trade and Real Income, G7 Minus the United States, 1951-1973
Percent
80
70
60
50
40
30
20
1951525354555657585960616263646566676869707172
currencies were anchored to its fixed price
through the U.S. comniitment to peg its price.
Until 1968 gold still served as backing to the
U.S. dollar with a 25 percent gold reserve
requiremnent against Federal Reserve notes; the
requirement mnay have served as a brake on
U.S. monetary expansion.
‘the first glimpse of a confidence crisis was
the gold rush of October 1960 when speculators
pushed the free market price of gold on the
London market up from $35.20 (the U.S. ‘treasury’s buying price) to $40. See figure 18. This
first significant runup in gold prices since the
London gold market was reopened in 1954 was
supposedly triggered by concet-ns over a Democratic
victory in the 1960 U.S. Presidential election.
73
ceeding months, the London Gold Pool, which
agreed to buy or sell gold to peg the price at
$35 an ounce, was formed between the United
States and seven other countries. The pool
became official in November 1961. For the next
six years, it succeeded in stabilizing the price of
gold but did not prevent a steady decline in the
U.S. monetary gold stock. See figure 13. In fact,
though the central banks in the seven other
countries supplied 40 percent of the gold
required to stabilize the price of gold, they
replenished their monetary gold stocks outside
the pool by converting outstanding dollar
balances into gold at the U.S. Treasury.”
During the period 1961—67, the United States
niade a series of arrangemnents to protect its
U.S. monetary authorities feared that private
speculation in the gold market might spill into
official demands fom conversion. Consequently,
remedial action was taken quickly. The Tmeasury supplied the Bank of England sufficient gold
monetary gold reserves. These included a network of swap arrangements with other central
banks, the issue of Roosa bonds, and moral suasion. France, however, did not go along with
to restore stability, and the monetary authori-
dollar in February 1965.
ties of the Group of ‘len countries agreed to
refrain from buying gold above $35.20. In suc-
these efforts and began its campaign against the
The period was marked by two sets of under-
“See Meltzer (1991).
MARCH/APRIL 1993
174
Figure 18
London Gold Price
Dollars per ounce
44
43
42
41
40
39
38
37
36
35
34
195455
56
57
58
59
60
61
62
63
64
66
66
67
68
69
70
71
72
lying forces that would undermnine the dollar’s
March 1968 the Gold Pool lost $3 billion in gold,
relationship to gold—gm-owing gold scarcity and
a rise in U.S. inflation. World gold production
leveled off in the mid-1960s and even declined
in 1966, while at the same time private demand
soared, precipitating a drop in the world monetary gold stock after 1966. Indeed, beginning in
1966,, the London Gold Pool became a net seller
of gold. Also, U.S. money growth accelerated in
1965, in part to finance the Vietnam War, and
with the U.S. share at $2.2 billion.” The
immediate concerns of the speculators may
have been fears of a dollar devaluation, but
according to Gilbert and Johnson, it reflected
inflation began to rise (figures 1 arid 15). ‘I’he
current account surplus began to deteriorate in
the underlying gold scarcity.” In the face of
the pressure, the Gold Pool was disbanded on
March 17, 1968, and a two-tier arrangement
replaced it. Henceforth, the monetary authorities of the Gold Pool agreed neither to sell nor
to buy gold from the market. They would transact only among themselves at the official $35
1964 (figure 14), as did U.S. competitiveness,
mirrored in a rise in the ratio of U.S. unit labor
price. In addition, on March 12, 1968, the
costs relative to trade weighted unit labor
7
costs.” The balance-of-payments deficit worsened between 1964 and 1966 but was reversed
reserve requirement against Federal Reserve
notes. The key consequence of these new
arrangenients was that gold was demonetized at
in 1966 by capital inflows triggered by tight
monetary policy.
After the devaluation of sterling, which the
United States tried unsuccessfully to prevent,
pressure mnounted against the dollar via the
London Gold mam-ket. From December 1967 to
“See Meltzer (1991).
“See Solomon (1976).
“See Gilbert (1968) and Johnson (1968).
FEDERAL RESERVE BANK OF ST. LOUIS
United States removed the 25 percent gold
the mat-gin. The link between gold production
and other market sources of gold and official
reserves was cut. Moreover, in the following
years, the United States put considerable pres-
sure on other mnonetary authorities to refrain
from converting their dollar holdings to gold.
175
By 1968 the international monetary system
had evolved very far indeed from the model of
the architects of the Articles of Agreemnent. Tn
reaction to both developments in financial markets and the confidence problem, the system
had evolved into a de facto dollar standard.
Gold convertibility, however, still played a role.
Though the major industrial countries tacitly
agreed not to convert their outstanding dollar
liabilities into U.S. monetary gold, the threat of
their doing so was always present. At the same
time, as the countries of continental Europe and
Japan gained economic strength relative to the
United States, they became more reluctant to
absorb outstanding dollars. They also were
reluctant to adjust theim surpluses by revaluing
their currencies, increasingly coming to believe
that adjustment should be undertaken by the
United States.
The system had also developed into a de facto
fixed exchange rate system. Unlike the classical
gold standard, however, where the fixed exchange
rate was the voluntary focal point for both
internal and external equilibrium, in the Bretton
Woods system exchange rates became fixed
because members feared the consequences of
allowing them to change. Nevertheless, because
of increased capital mobility, the pressure for
altering the parities of countries with persistent
deficits and surpluses became harder to stop
through the use of domestic policy tools and the
aid of international rescue packages. Pressure
increased from both academnic and official
sources for greater exchange rate flexibility.
By 1968, the system had also evolved a form
of international governance that was quite different fm’om that envisioned at the beginning.
Instead of a community of equal currencies
managed by the TMF, the system was managed
by the United States in cooperation with the
other members of the Group of Ten countries.
In many respects, it was closer to the key currency system proposed by Williams.”
According to Dominguez (1993), the IMF was
designed to facilitate international cooperation
by serving as a commitment mechanism. It was
to use its influence and its financial
to enforce the par value system. It did not,
however, have sufficient power to prevent
devaluations by major countries and its financial
resources were too limited to provide adequate
adjustment assistance for them. The IMF still
had an important role as a clearinghouse for
different views on monetary reform, as a center
of information, as the principal voice for the
countries of the world other than the Group of
Ten countries, as these countries’ primary
source of adjustment assistance and finally as
an important partner in the major Group of
Ten rescue packages.
In sum, the problems of the interwar system
that Bretton Woods was designed to prevent
reemerged with a vengeance. ‘the fundamental
difference, however, was that the system was
not likely to collapse into deflation as in 1931
but rather explode into inflation.
THE COLLAPSE OF BRETTON
WOODS
After the establishment of the two-tier arrangement, the world monetary system was on a defacto
dollar standard. The system became increasingly
unstable until it collapsed with the closing of
the gold window in August 1971. ‘the collapse
of a system beset by the fatal flaws of the gold
exchange standard and the adjustable peg was
triggered by an acceleration in world inflation,
in large part the consequence of an earlier
acceleration of inflation in the United States.
Before 1968, the U.S. inflation rate was below
that of the GNP weighted inflation rate of the
Group of Seven countries excluding the United
States (see figure 15). It began accelerating in
1964, with a pause in 1966—67. The increase in
inflation in the United States and the rest of the
world was closely related to an increase in
money growth and in money growth relative to
the growth of real output. (See figures 19 and
20.) Indeed, a prevalence of excess demand
shocks in the mid- and late 1960s is apparent
for the United States and other Group of Seven
countries in figures 11 and 12.
Darby et al (1983) provided considerable evidence on the transmission of inflation in the
“See Williams (1936 and 1943) and Johnson (1972b).
MARCH/APRIL 1993
176
Figure 19
Money (Ml) Growth Rates in the United States, Gland G7 Excluding the United States,
1951-1913
Percent
26
24
22
20
18
16
14
12
10
8
6
4
2
0
-2
195152535455565758596061626364656661686970717273
Figure 20
Money (Ml) Less Real Output Growth in the United States, Gland G7 Excluding
the United States, 1951-1973
Percent
0.25
0.2
0.15
0.1
0.05
0
-0.05
-0.1
195152 53 54 55 56 57 58 59 50 61 62 63 64 65 66 67 68 69 70 71 72 73
FEDERAL RESERVE BANK OF ST. LOUIS
177
Bretton Woods system. Their regression analyses led to a number of important conclusions.
First, U.S. inflation was caused by lagged U.S.
money growth. Second, U.S. money growth was
independent of changes in international
reserves.~~?the
balance of payments had no effect
on the Federal Reserve’s reaction function.
Third, U.S. money growth had strong and significant effects on money growth in seven
mnajor countries. These lags were very long—
up to four years—and reflected the fact that
central banks in the seven countries sterilized
reserve flows partially. Finally, money growth
in the seven countries explained inflation in
these countries with a significant lag.”
The key transmission mechanism of intiation
was the classical price specie flow mechanism
augmented by capital flows. Little evidence for
other mechanisms including commodity market
arbitrage was detected.” According to these
authors, the Bretton Woods system collapsed
because of the lagged effects of U.S. expansionary monetary policy. As the dollar reserves of
Germany, Japan and other countries accumulated in the late 1960s and early 1970s, it
became increasingly more difficult to sterilize
them. This fostered domestic monetary expansion and inflation. In addition, world inflation
was aggravated by expansionary monetary and
fiscal policies in the rest of the Gmoup of Seven
countries, as their governments adopted fullemployment stabilization policies. The only
alternative to importing U.S. inflation was to
float—the route taken by all countries in
1973.”
The crisis mounted from 1968 to 1971. The
U.S. current account balance continued to
deteriorate in 1968, but the overall balance of
payments exhibited a surplus in 1968 and 1969
thanks to a large short-term capital inflow. The
capital inflow was activated by events in the
eurodollar market. In the face of tight monetary
policy in 1968—69 and Regulation Q ceilings on
time deposits, deposits shifted from U.S. banks
to the eurodollar market. U.S. banks in turn
borrowed in the eurodollar market, repatriating
these funds. In 1970, as U.S. interest rates fell
“See Darby et al (1983)
“See Darby et al (1983).
‘“Except for the case of Japan, there is little evidence for
the leading alternative explanation for the collapse—that it
reflected growing misalignment in real exchange rates
between the united States and her principal competitors in
the face of differential productivity trends. See Marston
in response to rapid monetary expansion and
Regulation Q was suspended for large certificates of deposit, the borrowed funds returned
abroad and the deficit grew to $9 billion,
exploding to $30 billion by August 1971 (see figure 14). The dollar flood increased the reserves
of the surplus countries, auguring inflation. German money growth doubled from 6.4 percent
to 12 percent in 1971, and the German inflation
rate increased from 1.8 percent in 1969 to 5.3
percent in 1971.”~Pressure mounted for a
revaluation of the mark. In April 1971 the dollar inflow to Germany reached $3 billion. On
May 5, 1971, the German central bank suspended official operations in the foreign
exchange market and allowed the deutsche
mark to float. Similar action by Austria, Belgium, the Netherlands and Switzerland followed.1~5
In the following months, many began advocating ending the dollar’s link with gold. In April
1971, the U.S. balance of trade turned to deficit
for the first time and influential voices began
urging dollar devaluation. The decision to suspend gold convertibility was triggered by
French and British intentions in early August to
convert dollars into gold. On August 15 at Camp
David, President Nixon announced that he had
directed Secretary Connolly “to suspend temnporarily the convem-tibility of the dollar into gold
or other reserve assets.” The accompanying policy package included a 90-day wage-price
freeze, a 10 percent import surcharge and a 10
percent investment tax credit.”’
‘I’he U.S. decision to suspend gold convertibility ended a key aspect of the Bretton Woods
system. i’he remaining part of the system—the
adjustable peg—disappeared 19 months later.
The Bretton Woods system collapsed for three
basic reasons. First, two major flaws undermined the system. One flaw was the gold
exchange standard, which placed the United
States under threat of a convertibility crisis. In
reaction it pursued policies that in the end
made adjustment more difficult.
(1987) and Eichengreen (1992b).
“4See Meltzer (1991).
“See Solomon (1976).
“See Solomon (1976).
MARCH/APRIL 1993
178
The second flaw was the adjustable peg. Because
the costs of discrete changes in parities were
deemed high, in the face of growing capital
mobility, the system evolved into a reluctant
fixed exchange rate system without an effective
adjustment mechanism.
Finally, U.S. monetary policy was inappropriate for a key currency. After 1965, the United
States, by inflating, followed an inappropriate
policy for a key currency country. Though the
acceleration of inflation was low by the standards of the following decade, when superimposed on the cumulation of low inflation since
World War II, it was sufficient to trigger a
speculative attack on the world’s monetary gold
stock in 1968, leading to the collapse of the
Gold Pool.” Once the regime had evolved into
a de facto dollar standard, the obligation of the
United States was to maintain price stability.
Instead, it conducted an inflationary policy,
which ultimately destroyed the system.
DID THE BRETTON WOODS
SYSTEM OPERATE AS A SYSTEM
BASED ON CREDIBLE RULES?
One can view the Bretton Woods system as a
set of rules or commitment mechanisms.” For
nonreserve-currency countries the rules were to
maintain fixed parities, except in the contingency of a fundamental disequilibrium in the
balance of payments, and to use fiscal policy to
smooth out short-run distut-bances. The U.S.
enforcement mechanism—access to its open capital markets—was presumably its dominant
power because the IMF had little power.
For the United States, the center country, the
rule was to fix the gold pm-ice of the dollar at $35
per ounce and to maintain price stability. If a
majority of Bretton Woods members (and every
member with 10 percent or more of the total quotas)
agreed, however, the United States could change
the dollar price of gold. There was no explicit
enforcement mechanism other than reputation and
the commitment to gold convertibility. According
“See Garber (1993).
‘18 See Mckinnon (1992) for his version of the rules of the
Bretton Woods Articles and the dollar standard. Also see
Giovannini (1993) and Obstfeld (1993).
“See Mundell (1968).
“Giovannini’s (1993) calculations show that during the Bretton Woods convertible period credibility bounds on interest
rates for the major currencies, in contrast to the classical
gold standard, were frequently violated.
FEDERAL RESERVE BANK OF ST. LOUIS
to Giovannini (1993), the Bretton Woods system
was an asymmetric solution to Mundell’s n-i
currency problem.” The United States as the
nth country, had to mnaintain the nominal
anchor by following a stable monetary policy. In
addition, it had to supply the dollars demanded
by the rest of the world as reserves.
The rest of the world had to accept, through
its comnmnitment to fixed parities, the price level
set by the United States. But because of the adjustable peg, it had the option to change parities.
‘the rule was defective for the nonreserve currencies because the fundamental disequilibrium
contingency was never spelled out and no constraint was placed on the extent to which domestic
financial policy could stray from maintaining external balance. In addition, with growing capital
mobility, the option to change parities became
less viable.
For the United States this rule suffered from
a number of fatal flaws. First, because of the
fear of a confidence crisis, the gold convertibility requirement may have prevented the United
States in the early 1960s from acting as a center
country and willingly supplying the reserves
demanded by the rest of the world. Second, as
became evident in the later 1960s, this requirement was useless in preventing U.S. monetary
authorities from pursuing an inflationary policy.
Finally, although a mechanism was available for
the United States to devalue the dollar, monetam-y authorities were loath to use it for fear of
undermining confidence. No effective enforcement mechanism existed. Ultimately, the United
States attached greater importance to domestic
economic concerns than to its role as the center
of the international monetary system.
Thus although the Bretton Woods system can
be interpreted as one based on rules, the system
did not provide a credible commitment mech20
anism.1
The United States was unwilling to
subsume domestic considerations to the responsibility of maintaining a nominal anchor. At the
same time, other Group of Seven countries
became increasingly unwilling to follow the dictates of the U.S—imposed world inflation rate.
179
The failure of the Bretton Woods m-ule suggests a number of m-equirements for a welldesigned fixed exchange rate system. These
include the following:
• that the countries follow similar domes-
tic economic goals (underlying inflation
rates);
• that the rules be transparent; and
• that some central monetary authority
enforce them.
The recent EMS system was quite successful for
a number of years because it seemed to encompass these three elements. Its recent crisis, however, reflected the emergence of some of the
same problems that led to the breakdown of
Bretton Woods. I discuss these issues below in
the following subsection.
POST BREflON WOODS: MANAGED
FLOATING AND THE EMS
As a reaction to the flaws of the Bretton Woods
system, the world turned to generalized floating
exchange rates in March 1973. Though the eatly
years of the floating exchange rate were often
characterized as a dirty float, whereby monetary authorities extensively intervened to affect
both the levels of volatility arid exchange rates,
by the end of the 1970s it evolved into a system
where exchange market intervention occurred
primarily to smooth out fluctuations. Again in
the i980s exchange market intervention was
used by the Group of Seven countries as part of
a strategy of policy coordination.” In recent
years, floating exchange rates have been assailed
from many quarters for excessive volatility in
both nominal and real exchange rates, which in
turn increase macroeconomic instability and
raise the costs of international transactions.
The attack cites the favorable experience of
the EMS from 1987 to 1991 in producing exchange rate and price stability as a recommendation for a return to a global system of fixed
exchange rates. It is argued that recent attempts
at policy coordination can be formalized and extended to a more general managed system based
on either close policy coordination (to keep exchange rates within specified target zones) or a
renewed gold standard. In this paper I do not
consider the mci-its or drawbacks of policy
coordination in genem-al, but I examine the EMS
briefly as a monetary regime similar to Bretton
Woods.” Of interest is whether lessons for the
international monetary system can be derived
from its experience.
The EMS, like the Bretton Woods system,
represents an agreement among countries to set
exchange rate parities, to manage intra-European
Community exchange rates and to finance exchange market intervention. Like Bretton Woods,
it is an adjustable peg system.
The origins of the EMS date back to the Bretton
Woods period. The case for stable exchange
rates within Europe was made in the context of
the European Common Market (EEC). In addition to a strong dislike by Europeans for flexible
exchange rates—based on their perception of interwar experience and their belief that exchange
rate volatility reduces trade in highly open
economies—the key motivation for extensive
policy coordination to stabilize exchange rates
was the common agricultural policy established
in 1959.123
Food prices in the comnmunity at-c set in terms
of a central unit of account (the ECU) but quoted
in local currency. Consequently, any changes in
exchange rates lead to changes in local prices.
During the Bretton Woods era, a system of subsidies and taxes was worked out to insulate the
local economy from policy realignments. ‘I’his
led to an asymnmetm’ic adjustment between hard
currency countries reluctant to lower their
agricultural prices and soft curm’ency countries,
which allowed their prices to rise. The result
was overproduction of agricultural products
and an ever-increasing fraction of the EEC
budget allocated to subsidize agriculture.
Early attempts to stabilize intra-European
exchange rates during the Bretton Woods era
were unsuccessful, as was the Snake in the
Tunnel agreement of the 1970s. The EMS, established in 1979, was a formal attempt to overcome
earlier obstacles to exchange rate stabilization.
It was designed to prevent the defects of the
Bretton Woods system, including: the asymmetric
adjustment mechanism, with the United States
as the center, setting the tune fom- the rest of
~2’ See Bordo and Schwartz (1991).
“2See Feldstein (1988) and Bordo and Schwartz (1989a).
“See Giavazzi and Giovannini (1989).
MARCH/APRIL 1993
180
the world; the problems associated with growing capital mobility; and the dramas of parity
realignments. Instead, the EMS designed a set of
intervention rules that would produce a symnmnetric system of adjustment; create a mechanusm
to finance exchange market interventions; and
establish a code of conduct for realigning parities.”4
Like Bretton Woods, the EMS was based on a
set of fixed parities called the exchange rate
mechanism (ERM). Each country was to establish a central parity of its currency in terms of
ECU, the official unit of account. The ECU consisted of a basket containing a set number of
units of each currency. As the value of currencies varied, the weights of each country in the
basket would change. A parity grid of all
bilateral rates could then be derived from the
ratio of members’ central rates. Again, like Bretton Woods, each currency was bounded by a
set of margins of 2.25 percent on either side of
parity, creating a total band of 4.5 pet-cent (for
Italy, and later the United Kingdom, when it
joined the ERM in 1990, the margin was set at 6
percent on either side of parity). ‘t’he monetary
authorities of both the depreciating and appreciating countries were required to intervene
when a currency hit one of the margins. Countries were also allowed, but not required, to
undertake intramarginal intervention. The indicator of divergences, which measured each currency’s average deviation from the central
parity, was devised as a signal for the monetary
authorities to take policy actions to strengthen
or weaken their currencies. It was supposed to
work smnietrically.
Intervention and adjustment was to be
financed under a complicated set of arrangements. i’hese arrangements were designed to
overcotne the weaknesses of the IMF’ during
Bretton Woods. ‘the very short-term financing
facility (\T5~’t’F)was to provide credibility to the
bilateral pam-ties by ensuring unlimited financing
for marginal intervention. It provided automatic
unlimited lines of ct-edit from the creditor to
the debtor members. The short-term monetary
support (STMS) was designed to provide shortterm finance for temporary balance of pay‘“See Giavazzi and Giovannini (1989).
‘21
At its outset, there was considerable doubt that the EMS
would be successful at withstanding the strains of greatly
divergent money growth and inflation rates among its
members. See Fratianni (1980). See Giavazzi and Giovannini (1989); Fratianni and von Hagen (1990 and 1992); and
Meltzer (1990).
FEDERAL RESERVE BANK OF ST. LOUIS
ments disequilibration. The medium termn financial assistance (MTFA) would provide longer
term support.
Unlike Bretton Woods, where members (other
than the United States) could effectively decide
to unilaterally alter theim parities, changes in
central parities were to be decided collectively.
Finally, like Bretton Woods, members could (amid
did) impose capital controls. These have recently
been phased out.
The evidence on the performance of the EMS
indicates that it was successful in the latter half
of the 1980s at stabilizing both nominal and real
exchange rates within Europe, at producing credible bilateral bands and at reducing divergence
between members’ inflation rates.”
Giavazzi and Pagano (1988), Giavazzi and
Giovannini (1989), and Giovannini (1989) make a
strong case that the success of the EMS was
largely due to the fact that it was an asymmetric system with Germany acting as the center
country. The other EMS members adapted their
monetary policies to maintain fixed parities with
Germany. Also, according to the aforementioned
writers, the Bundesbank exhibited a strong credihle commitment to low inflation and the other
members of the ERM, by tying their currencies
to the deutsche mark, used an exchange rate
target as a commitment mechanism to successfully reduce their own rates of inflation. Evidence
for the asymmetry hypothesis is based on the
fact that the Bundesbank intervened only when
bilateral exchange rates were breached, whereas
the other countries engaged in intra-marginal
intervention, and on evidence of asymmetrical
behavior of interest rates in Germany and the
other EMS countries. In the period preceding
several EMS realignments, non-German EMS
interest rates changed drastically, whem-eas no
change was observed in their German counterpart. Evidence that the Bundesbank’s reputation
was responsible for the disinflation of the 1980s
is based on an out-of-sample simulation of a
VAR to pmedict the inflation rate. Downward
shifts in the predicted values of inflation for a
number of countries after the advent of the
EMS makes the case. That inflation expectations
181
were significantly reduced only in France and
Italy several years after the advent of the EMS
(the argument goes) may reflect slow learning
or alternatively that these countries used the
EMS to justify following unpopular austerity
policies.
Fratianni and von Flagen (1990 and 1992) dispute
both the asymmetry and the imported disinflation
hypotheses.” Evidence based on Granger causality tests from a structural VAR suggests that the
German monetary base was not insulated from
other EMS base movements nor were non-German
EMS monetary bases insulated by the German
monetary base from external shocks. In this
interpretation, the EMS is a coordinated monetary policy system with all members playing
a role.
Finally, Fratianni and von Hagen (1990) provide evidence that the EMS has reduced intraEuropean exchange rate volatility; however, this
reduction has been at the expense of increased
volatility of non-EMS currencies. Thus they
argue that the EMS is on net balance beneficial
to welfare because intra-EMS trade exceeds
external trade. They also show that although
the advent of the EMS has not reduced inflation
uncertainty relative to non-EMS countries, it has
reduced the effects of fomeign inflation shocks
on the mnemnbers.
Despite its favorable performance since the
mid—1980s, the EMS was recently subjected to
the same kinds of stress that plagued Bretton
Woods. September 1992 and November 1992
marked a series of exchange rate crises in
Europe that paralleled the events of 1967 to
1971. Precipitated by concerns that French voters would reject the Maastricht Treaty on Euro1jean Monetary Union in a referendum on
September 20, speculators staged attacks early
in the month on the Nordic curm-encies and then
later on the Italian lira, the British pound, the
French franc, and other weaker currencies. The
crisis led to the disabling of the ERi~t.Both Italy
and the United Kingdom left it while Spain,
Portugal and Ireland reimposed or strengthened
existing capital controls: in Novemnher Sweden
floated and Portugal and Spain devalued.
The fundamental causes of the crisis, like
the crises that plagued Bretton Woods, lay in
large part with the exchange rate system. The
EMS, like Bretton Woods, is a pegged exchange
rate system that requires member countries to
follow similar domestic monetary and fiscal
policies and hence have sintilar inflation rates.
This is difficult to do in the face of both differing shocks across countm-ies and differing national
priorities. Under Bretton Woods, capital controls and less integrated international capital
markets allowed members to follow divergent
policies for considerable periods. Under the
EMS, the absence of controls (after 1990) and
the presence of extremely mobile capital meant
that any movement of domestic policies away
from those consistent with maintaining pam’ity
would quickly precipitate a speculative attack.
Also, just as under Bretton Woods, the adjustable peg in the face of such capital mobility
became unworkable. Thus the difference
between the two regimes when faced with
asymmetric shocks or differing national priorities was the speed of reaction by world capital
markets.
Though the fundamental cause of the crisis
was similar in the two regimes, the source of
the problem differed. tinder Bretton Woods, the
shock that led to its collapse was an acceleration of inflation in the United States, ostensibly
to finance the Vietnam War’, as well as social
policies, and to maintain full employment.
Under the EMS, the shock was bond financed
German reunification and the Bundesbank’s subsequent deflationary policy. In each case, the
system broke down because other countries
were unwillimig to go along with the policies of
the center coum1try..~l~he
commitments to price
stability by both the center country and the
other members were not shown as credible.
Under Bretton Woods, Germany and other western European countries were reluctant to
inflate or revalue and the United States was
reluctant to devalue. Under the EMS, the United
Kingdom, Italy, Spain, Portugal, Ireland and
Sweden were unwilling to deflate amid Germany
was unwilling to revalue. As under Bretton
Woods, although the EMS had the optiomi for a
“Also, Collins (1988) and Eichengreen (1992d) present evidence that EMS membership may not have been responsi-
ble for reducing the inflation rates of EMS countries. Their
cross-country regressions show that EMS membership had
little effect on inflation performance. Changing public attitudes toward inflation within each country represent a
more important determinant. See Giavazzi and Collins (1992).
MARCH/APRIL 1993
182
general realignment, both imnproverl capital
mobility and the Maastricht commitment to a
unified currency made it an unrealizable
outcome.
Thus the lesson from both the EMS and Bretton Woods is that pegged exchange rate systemns
do not work for long no matter how well they’
are designed. Pegged exchange rates, capital
mobility and policy autonomy just do not mix.
During the heyday of Bretton Woods years ago,
the case made for floating exchange rates for
major countries still holds. This is not to say
that if Eum-opean countries wet-c completely willing to give up domestic policy autonomy, they
could not eventually form a currency union
with perfectly fixed exchange rates. In an
uncertain world subject to diverse shocks, the
costs fom- individual countries of doing so are
apparently extremely high.
CONCLUSION
This paper examines statistical evidence on
the performance of alternative monetary
regimes over the past century. It also examines
some aspects of the history of these regitnes.
Both statistical and histom-ical evidence may help
provide answers to the question why some
regimes have been more successful than othem’s.
They also have implications for current issues
in international monetary reform and the ongoitig debate over rules and discretion.
‘the statistical evidence on performance of
alternative monetary regimes in the second section leads to the conclrtsion that the Bretton
Woods convertible regime from 1959 to 1970
was by far the best on virtually all criteria, but
that the recent floating regime is not much
worse. Indeed, it is clear that the performance
of the regimes in the post—World War II era is
superior to the perlormance of m-egimes in the
preceding half century. Finally, though the classical gold standard does relatively poorly in
terms of the stability of real variables, it performed best on inflation persistence and financial
miiarket integm’ation—evidence for the successful
operation of gold as a nominal anchor.
This evidence leads to the following question:
Why was Bretton Woods so stahle yet so fragile
and the classical gold standard so unstable and
yet so durable? ‘l’he ansiver may he due in part
to the shocks the two regimes faced. This, however, seemns unlikely because the gold standard
was subject to both supply and demand shocks
FEDERAL RESERVE BANK OF ST. LOUIS
that were a multiple of those facing Bretton
Woods. It could also be due to greater flexibility
of wages and prices and greater factor mobility
before World War I, which meant that adjusting to the greater shocks did not have as serious
consequences on real activity and employment
as later in the twentieth century. Alternatively,
political economy factors—such as a more
limited suffrage; less concern over the maintenance of full employment; limited understanding of the link between monetary policy and the
level of economic activity; and hence loss of an
incentive for monetary authorities to pursue
policies that would threaten adherence to
convertibility—could be responsible. These
hypotheses clearly need mom-c investigation.
It also could be due to regime design and
especially the incentive compatibility features of
the regime. The classical gold standard may have
been so successful because of the credibility of
the commitment to the gold standard rule of
convertibility and because of its neam universal
acceptance. In turn, the credibility of the gold
standard may stem fm’om the origins of gold as
money and the importance of Great Britain, the
most impom-tant commercial nation of the nineteenth century, in enforcing the mules. England’s
commitment to convertibility in turn was aided
by stabilizing private capital flows.
The classical gold standard for the core countmies worked as a contingent rule or a rule with
escape clauses. As a consequence, it was flexible
enough to withstand major shocks, It also enabled governments to finance major wars flexibly, by allowing them to leave the gold standamcl
and temporarily use seigniorage to finance
unusual government expenditures. The rule
may have endured because the requisite deflation required to restore convertibility after the
emnergency had passed may not have had severe
effects on real variables. This may have been
because wages and prices were highly flexible.
Alternatively the deflation accomnpanying resumption may have had significant real effects
hut no political constituency strong enough to
oppose it existed.
The classical gold standard collapsed under’
the unprecedented shocks of World War I. It
was reinstated as the short-lived gold exchange
standard. Its hrief life reflected the fatal flaws
made famous by the ‘t’riffin dilemma. But regardless of the weakmiess of the gold exchange standard, it suffered from the absence of an effective comnmnitnient mechanism. ‘there was no cen-
183
ter country to enfom’ce the rule, just three rivals
pulling in different directions. Also, it was the
beginning of an era when countries were less
willing to go along with the gold convertibility
rule because they attached greater weight to
the objective of domestic economic stability.
The Bm’etton Woods system was set up to prevent the perceived flaws of the classical gold
standard and the trauma of the interwar
period. The Bretton Woods adjustable peg was
in some respects similar to the gold standard
contingent rule, but it invited speculative
attacks, hence compromising its role as an
escape clause. Bretton Woods evolved into a
gold exchange standard fraught with the adjustment, liquidity and confidence problems of the
interwar period. Though the problems of the
gold exchange standard could possibly have been
corrected by raising the price of gold, as it turned
out, it evolved into an asymmetric dollar standard. The United States maintained the credible
commitment to a noninflationary policy for only
a few years. By the mid-1960s it shifted to an
inflationary policy to further its domestic interests. The rest of the world, faced with imported
inflation, soon lost the incemitive to follow U.S.
leadership and the system collapsed in 1971.
The advent of the general floating exchange
rate system in 1973 and its longevity suggests
that the lessons of Bretton Woods have been
learned well. Countr’ies are not willing to subject their domestic policy autonomy to that of
another country of whose commitment they
cannot be sure in a stochastic world nor to a
supernational monetary authority they cannot
control. The key advantage of floating exchange
rates stressed a generation ago by Milton Friedman and Harry Johnson—the freedom to pursue
an independent monetary policy—still holds today.
Major countries can design domestic monetamy
policy rules to achieve domestic pt-ice stability
without the costs of giving up their policy
autonomy
-
The experience of the EMS reveals that countmies that have similar goals and face similar
shocks can establish a regional exchange rate
regime. This m-egime requires both a credible
commitmemit mechanism and the willingness of
member countries to give up sovereignty fom’ a
higher purpose. As attested to by the events of
September and November 1992, however, the
durability of such an arrangement seems doubtful, as was the case for Bm’etton Woods, in an
uncertain world subject to diverse shocks
where national priorities can change and commitmnents can be broken. Some have amgued
that the EMS can be preserved only by precommitment to price stability and fixed exchange
rates by independent central banks.’” Others
argue that the only solution is rapid movement
to a unified currency enforced by a European
central bank.” As Feldstein (1992) points out,
however, full-fledged monetary union completely precludes the use of domestic monetary
policy. To the extent that country-specific
shocks dominate common shocks and labor is
relatively immobile between European countries, the benefits of permanently fixed
exchange rates may riot outweigh the cost of
increased economic dislocation.”
Finally, proposals for monetary reform, such
as exchange rate target zones or targeting the
real price of gold, though possibly of scientific
merit, would work only if nations are willing to
give up domestic autonomy and follow credible
commitments. The history of international
monetary regimes casts doubt on the likelihood
that the nations of the world will do so in the
forseeable future.
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_______
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_______
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_______
MARCH/APRIL 1993
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Appendix Figure 1
Supply and Demand Shocks: 1880-1989, Including the War Years, Annual Data,
United States
Percent
1880
1890
1900
1910
1920
1930
1940
1950
1960
1970
1980
Supply and Demand Shocks: 1880-1989, Including the WarYears, Annual Data,
United Kingdom
Percent
14
12
10
864-
2-2
-4
-6
-8-10-
-12
-14
-16
-18
1880
1890
1900
1910
1920
1930
1940
1950
1960
1970
1980
MARCH/APRIL 1993
190
Appendix Figure 1 (continued)
Supply and Demand Shocks: 1880-1989, Including the WarYears, Annual Data, Canada
Percent
—1
1880
1890
1900
1910
1920
1930
1940
1950
1960
1970
1980
Supply and Demand Shocks: l880-1989, Including the WarYears, Annual Data, Italy
Percent
1880
1890
1900
1910
FEDERAL RESERVE BANK OF ST. LOUIS
1920
1930
1940
1950
1960
1970
1980
191
Appendix Figure 1 (continued)
Supply and Demand Shocks: 1880-1989, Including theWarYears, Annual Data, 04
Percent
1
—1
—1
-20-24
1880
1890
1900
1910
1920
1930
1940
1950
1960
1970
1980
MARCH/APRIL 1993